Officials at the meeting of the Open Market Committee of the Federal Reserve System voted in the middle of December 2013 to begin “tapering” the Fed’s purchase of securities in the open market.
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Up until then, the Federal Reserve had been attempting to acquire approximately $85 billion of securities from the open market every month. This was the Fed’s third effort at Quantitative Easing (QE), an attempt to make sure that United States financial markets had sufficient liquidity to spur on the economic recovery, which began in July 2009 to reduce the unemployment rate to more acceptable levels.
One of the fears that investors in bonds had last fall was that any effort to begin tapering Federal Reserve purchases would result in higher bond rates. Let’s look at what has happened over the roughly two months since the tapering of purchases began.
The meeting of the Open Market Committee took place on December 17 and 18. The balance sheet of the Federal Reserve is constructed every Wednesday, as the banking week, for Federal Reserve purposes, goes from Thursday through Wednesday. The Fed chose to measure the banking week this way so as to avoid “closing the books” on a Friday because of all the “noise” generated by weekend banking transactions. It was argued that a more meaningful measure of the position of the Fed would be achieved if the banking week ended in the middle of the week rather than at the end of the week.
The week immediately following the meeting of the Open Market Committee was Christmas week. Usually, the Federal Reserve puts reserves into the banking system at this time to provide liquidity for all the transactions and movements of funds that take place during this week. This year, the Fed bought a net of $23.0 billion in US Government securities and mortgage-backed securities in the Christmas week alone! It is hard to count this week into the tapering effort.
In the four-week period from December 25, 2013 through January 22, 2014, the Federal Reserve added $65.2 billion in US Government securities and mortgage-backed securities to its portfolio.
From January 22 until February 19, another four-week period, the Federal Reserve added another $65.7 billion in these securities to its portfolio.
Whatever one takes as the start of the tapering exercise, the Federal Reserve, for the past eight weeks, has reduced the amount of securities it is purchasing on a regular basis. Still, buying even $65 billion per month is putting a lot of new liquidity into the financial markets.
If one goes back to the period just before the financial problems began, in early August 2007 (the Great Recession began in December 2007), the total value of securities held by the Federal Reserve amounted to $784 billion.
Adding $65 billion to the Fed’s securities portfolio in one month amounts to more than 8.0 percent of the total securities portfolio held by the Federal Reserve on August 1, 2007.
Given the slowing in these purchases, bond interest rates went up…right?
Well, on December 18, 2013 the yield on the 10-year United States Treasury bond was 2.89 percent. By the end of December, the yield had risen to 3.00 percent. But, then the yield began to decline. At the close of business on February 26, the yield had dropped to 2.67 percent.
Well, what happened was that investors got very nervous about the sovereign debt of many emerging markets countries. During the period of quantitative easing, a lot of the money the Federal Reserve created flowed out of the United States and helped to support the sovereign debt issues of many of the emerging markets countries.
The very threat of the Federal Reserve beginning to “tighten” up its monetary policy by beginning to taper its purchases tended to frighten many investors that had put money into this sovereign debt.
Guess what? With the possibility that the Federal Reserve would taper its purchases, these investors assumed that this would be detrimental for this debt and so began selling the securities and sending the proceeds of the sales back into the United States…back into US Treasury securities.
The actions by the Federal Reserve had the effect of drawing cash back into the United States and this had the result of lowering longer-term interest rates.
The point is, Federal Reserve actions don’t always control what is going on in the longer-term bond markets. Whereas, the Fed might be very able to impact short-term interest rates, its potential effect on longer-term interest rates is much weaker. An investor in longer-term bonds must be aware of a lot more things in understanding long-term interest rates than just the current actions of the Federal Reserve.
There is another relatively current example of this. At the beginning of 2011, the yield on the 10-year Treasury security was trading around 3.5 percent. That spring, things started to fall apart in European financial markets and there was a substantial flow of “risk averse” funds into the American financial markets. The yield on the 10-year Treasury dropped to around 2.0 percent by the middle of 2011 and then fell to a low of 1.5 percent in the summer of 2012.
This movement in interest rates was not due to the quantitative easing of the Federal Reserve although many analysts claimed that it was. The drop in the Treasury yield was more connected to relevant events in Europe than to anything that the Fed did or was doing.
Then, as things began to improve in Europe in the first half of 2013, the flow of funds reversed itself. As a consequence, the yield on the 10-year Treasury began to rise, increasing back into the range around 3.0 percent. This move was not connected with any Federal Reserve actions.
The point of this analysis is that longer-term interest rates are less under the control of the Federal Reserve than many people think. As I have written before, one way of trying to understand the level of long-term interest rates is to perceive the long-term interest rate being composed of the expected real rate of interest and inflationary expectations…plus the effects of any extraordinary circumstances like the international flows of funds just described.
If one compares the markets’ expectations of inflation in the middle of December 2013, just before the Fed’s tapering began, the inflationary expectations built into the 10-year rate of interest was about 2.20 percent per year. As of the close of business on February 26, the markets’ expectation of inflation was 2.17percent. In other words there was no change in inflationary expectations during this period of time.
Take the inflationary expectations away from the current yield on the 10-year Treasury security and you have a figure that is supposed to be a combination of the real rate of interest and the impacts of flows of funds into or out of the United States due to things like risk averse money flowing out of emerging markets countries.
This remainder needs to be explained to your satisfaction by the various events that are going on.
About John Mason
John has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.
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