While most fear the end of QE, we think it’s more appropriate to celebrate. Photo by Getty Images/Ben A. Pruchnie.
It’s official—quantitative easing (QE) is no more. The Fed announced Wednesday the final round of bond buying will take place in November, sparking a series of grandiose epitaphs. Some suggest QE was a big bull market boost, some call it a lifeline for the economy, and many suggest it was a dud for Main Street but a boost for Wall Street. But in our view, Wall and Main are often one in the same, and QE boosted neither—instead weighing on growth by discouraging lending. Investors and everyday folks alike should cheer its end.
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QE will end just shy of its sixth birthday. On November 25, 2008 then-Fed head Ben Bernanke unveiled plans to begin buying up to $500 billion in mortgage-backed securities in an effort to boost liquidity, free up bank balance sheets and drive demand for new loans. Bond buying began in January 2009 and ran through March 31, 2010. But one round wasn’t enough for our fearless Fed: QE 2, which added US Treasurys to the menu, ran from November 3, 2010 to June 30, 2011 and added $600 billion to the Fed’s balance sheet. A weird, wrongheaded interlude called Operation Twist ran from September 2011 to December 2012, as the Fed “twisted” its balance sheet longer term by swapping its shorter-term Treasurys for medium and longer-term. The most recent round, QE3, started September 13, 2012 and became QE-infinity in December 2012, when the Fed decided they would buy however many bonds for however long they wanted until they felt like they didn’t want to buy anymore (based on an ever-shifting set of data points, variables and, we’ll say it, whims).
QE sought to stimulate the economy, by incentivizing borrowing through ultra-low interest rates. So how’d they do? QE1 was alright. It boosted liquidity when credit was frozen and the US risked deflation. The yield curve steepened nicely through most of it, too. But the rest were a drag. They pulled down long-term rates. US 10-year Treasury yields spent much of 2012 and 2013 below 2%—far below historical norms. (Exhibit 1)
Exhibit 1: 10-Year Treasury Yields
Source: St Louis Federal Reserve and FactSet, as of 10/31/2014. 10-Year Treasury Constant Maturity Rate 11/25/2008 – 10/30/2014.
This is to be expected. Bond prices and yields sit on opposing sides of a seesaw. Buying a bunch (or a few hundred billion worth, as it were) will drive up prices some. Yields will likely fall. Hooray! Low yields! Mission accomplished!
Or not. Despite the unprecedented monetary stimulus, the current expansion has been the slowest since WWII, perplexing many. The Fed’s balance sheet shot up to more than $4 trillion during the QEs. To many, the US was awash in liquidity. Interest rates were near historic lows. Even the words in the Fed’s statements were up massively, giving clarity![i] So what was the problem? The Fed’s actions didn’t increase broad money supply—only bank lending in our fractional reserve system can materially move the needle on that. And here it seems the Fed omitted one very important piece to this puzzle: QE is demand-side monetary policy, near exclusively. The Bernanke Fed’s policy targeted low rates to bring more borrower demand. But it said nothing of supply.
Prices, in a capitalist economy, are the mechanism for balancing demand and supply. Interest rates are merely the price of money. Too low, and banks likely won’t boost supply. Banks aren’t charities. They require profit to make loans. Yet the way they profit from lending hinges on the yield spread—the difference between short- and long-term interest rates. It’s a proxy for bank profitability—banks borrow short term (think deposit accounts and bank-to-bank overnight loans) and lend long (business loans, mortgages, etc.), pocketing the difference. This is called the net-interest margin in bankerspeak. Wider yield spreads mean more profitable loans, an incentive to lend more. This is why the yield spread has been considered an excellent gauge of future economic conditions for roughly a century.
When the Fed bought bonds under QEs 2 and 3, they lowered long yields, while short-term yields stayed near zero—flattening the yield spread.[ii] (Exhibit 2). This had a huge influence on lending of all forms, as Treasurys—widely considered a credit-risk free rate—are the starting reference point for loans of many varieties.
Exhibit 2: Yield Spread
Source: FactSet, as of 10/30/2014. US Treasury Yield Curves on 12/31/2009, 12/31/2010, 12/30/2011, 12/31/2012, 12/31/2013 and 9/30/2014.
QEs 2 and 3 amounted to pushing on a string. Even if the Fed spurred massive demand, banks may not have felt sufficiently compensated for the risk of lending. Lending provides access to capital necessary for some firms to finance expansion or new equipment and for individuals to buy a house or do myriad other things that could spur economic activity. If loan growth is anemic—as it has been throughout the current expansion—economic growth will likely be similarly slow. This isn’t to say growth has been terrible. Despite QE’s deflationary impact, the US has grown for years. But it is clearly an “in spite of,” not a “because of.”
Need more evidence? Consider how credit markets have changed since Bernanke alluded to tapering QE in May 2013—a bout of jawboning that drove up long-term rates as investors began pricing in the program’s end, widening the yield spread. Contrary to widely held fears, lending didn’t crater. Since January, loan growth has perked up!
Interest rates have fallen some since then, but not all the way back to pre-taper-talk levels—the yield curve remains steeper today than in early May 2013. And with the Fed officially now out of the way, it wouldn’t surprise us to see rates drift a bit (not hugely) higher from here. Either way, we expect that to the extent the yield spread has narrowed this year, the clarity offered by ending QE helps mitigate any potential impact on lending. This could also have contributed to loan growth’s upturn beginning in January 2014—the official announcement of the first taper was in December 2013, for implementation in January. Tellingly, despite lower rates, the yield spread’s contribution to The Conference Board’s Leading Economic Index (LEI) hasn’t dwindled much. The Leading Credit Index, which gauges credit availability, has also stayed fairly consistent. (Exhibit 3)
Exhibit 3: Interest Rate Spread and Leading Credit Index Contributions to LEI Growth
Source: FactSet, as of 10/30/2014.
With QE out of the way, one recent economic drag has been removed. For this we’re thankful. But some suggest QE is now a permanent tool in the Fed’s toolkit—that if growth tails off or inflation expectations falter significantly, the Fed could fire its demand-side-bond-buying bazooka up. We’d hope the experience in this cycle serves as a cautionary tale: Abandoning a century of effort to balance demand and supply of lending has had poor results in this cycle. If the Fed learns the wrong lessons and implements QE at the wrong time, the consequences could be far worse.
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[i] Or not. More words don’t mean more clear, it usually means more obfuscation. But then again, we aren’t sure the Fed telegraphing where exactly it would go is good, either. But of course, they didn’t do that, they said they would go one place, then went another, rinse, wash and repeat.
[ii] Operation Twist was even worse, as it promoted higher short-term yields while lowering long-term yields.