Long bond investors see opportunities

Federal Reserve Chairman Ben Bernanke continues to stand against allowing the U.S. economy to enter a period of deflation, an economic condition he believes would spell long-lasting financial hardship for Americans. His solution — the centrepiece of a monetary control philosophy often referred to as the Bernanke Doctrine — is to open the valves of the U.S. money supply and let the dollars flow into the economy. The availability of so much cheap money, the theory goes, would stimulate spending in all corners and give the economy a much-needed nudge towards a renewed era of sustained growth.

Such is the thinking behind the first round of Quantitative Easing (QE1), launched in the fall of 2008, and its successor, QE2, announced in early November 2010 and expected to run until June 2011. The keystone strategy of QE2 is a concerted push by the Fed to buy back large quantities of mid-term U.S. Treasury bonds on the open market in a bid to hold down interest rates and stimulate the economy.

How well is quantitative easing working?

The best barometer of how well the second round of quantitative easing is working is to review how the markets have responded to the initiative thus far.

The fixed income and equity markets actually started to react to rumours of the program back in August 2010, when the markets first sensed something big was coming down the pipe. The irony is to this point, the rumours of QE2 may have achieved more of the desired effects than the program itself.

QE2’s goal was to add money to the financial system and lower mid-term interest rates, thus stimulating the economy. As mentioned, the mid-rates started to fall as soon as the rumoured Fed buyback hit the Street. However, since the announcement of QE2, the rates have risen to the same level as prior to QE2 being considered a possibility. In other words, the strategy isn’t working.

Dramatic march upward for long bond yields

Interestingly, when mid-rates started to fall in the summer, 30-year Treasury bond interest rates actually began a dramatic march upward as investors worried the QE2 program would have an inflationary impact on the economy. Long rates took a different path and have not yet pulled back, and the economy’s modest strengthening is keeping investors worried that inflation will return.

Meantime, the U.S. stock market has risen approximately 20% since the middle of the summer. This reversal in fortunes came as the double-dip recessionary scenario that many had been calling for began to fade and the broader economy began to strengthen in a moderate fashion. At the moment, the stronger stock market is providing comfort to investors and improving consumer sentiment.

What would have happened had Bernanke and the Fed let the market run its course? The most likely scenario is that long rates would be lower, mid-rates would be unchanged and the equity markets would still be the wild card they are now.

Since the introduction of QE2, the equity markets have risen, albeit due to many factors that had nothing to do with the Fed’s intervention. The Obama Administration’s extension of the $858 billion in Bush tax cuts and strong consumer demand over the December holiday season could each have done as much as QE2 to account for this strength.

To put it bluntly, QE2 is not accomplishing its stated objectives. In fact, QE2 has added another unnecessary element of risk to the financial system. Long U.S. Treasury bonds hold some attraction as the markets wake up to the failure of QE2 and the economy picks up less steam. Long bond yields will fall, and investors will be rewarded accordingly.