I saw a video from an Economist, who spoke to the Fed’s balance sheet. In the video he says the following:
When the Fed increases its balance sheet (QE) the 10 year treasury yield will go up. The inverse also holds true, if the Fed unwinds its balance sheet (QT) the 10 year treasury yield goes down.
I would have said as the Fed increases money supply by buying treasuries (QE) it floods the market with money making money cheaper and hence lowering yields. The opposite holds true with QT.
Can someone explain why, QE increases yields on the 10YR treasury and QT lowers yields on 10YR treasuries.
What am I missing?
Thanks.
So think of QE as being equivalent to interest rate cuts. When the FED cuts rates, currency depreciates and the bond yields would spike to compensate investors for the lower currency value. Similarly in QE, when the FED infuses more funds into the markets, what happens is the supply for money increases (assuming all else equal) which in turn again depreciates your USD and this will lead to spiking of bond yields.
The short and Mid term rates will go down, the long term rates will Go Up due to inflation
If the Fed increases its balance sheet it’s buying treasuries and injecting capital into the system.
More capital means lower rates. I’m good up to here!
Now! Assuming all this capital is distributed across other institutions and they seek to purchase treasuries (safe haven). Would the demand increase bond prices and lower yields across maturities?
I’m referring to treasury yields, especially the 10yr.
I also see how corporates would want to attract investors by increasing yields.
The point of a QE is to stimulate growth by raising capital at lower costs. Institutions won’t use that money to buy more treasury secs. Also, assuming all else equal (no major changes in economy), a cap infusion would be considered adding undue supply in the markets, which will make your currency lose value and due to this loss in currency value, investors (mainly global) will demand a higher premium on bonds to compensate for currency depreciation risk, which will lead to an increase in your T-bond yields.
To your second part, entering high yield bonds would actually attract more investors given the economy is on the verge of expansion. So that doesn’t have a clear answer as it is very scenario dependent.
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Saurabh!
So would increasing QE and the fed cutting rates have the same impact on treasury yields?
Let me be a bit more detailed this time. In case of surplus liquidity in the markets, QE or rate cuts will have a negative impact on currency, increasing your yields due to excess supply.
If there is demand for liquidity, QE or rate cuts would depreciate your currency and your yields will fall as well due to lower premiums demanded for increased capital in the market as capital can now be raised at lower costs.
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