Why Quantitative Easing Will Raise Long-Term Rates

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


The two-year treasury yield fell to another record low on Monday, touching 0.3987%. The 10-year treasury yield was up slightly however in September, rising for the first time since March. Federal Reserve money-printing is behind both falling shorter-term rates and rising longer-term rates.

A survey by Bloomberg of more than 60 mainstream economists indicates they expect 10-year treasury yields to keep rising in 2010 and through 2011. Perhaps someone has been passing around some notes on the approximately 500 hundred year old 'quantity theory of money', which states if the amount of currency is increased without an appropriate increase in economic growth, inflation will result (and consequently interest rates will have to rise, with the biggest increase taking place on long-term bonds).  For this not to happen, the laws of simple arithmetic have to be violated. The Federal Reserve has essentially been maintaining that that is what has taken place for the last two years. Bernanke of course does not directly state that we have entered a new economic age where two plus two no longer equals four because he would be laughed out of Washington and even the never questioning U.S. mainstream media wouldn't print such garbage.

Bloomberg also reports that a survey of primary dealers (the people who buy the paper that the Treasury issues) estimates that the Fed will buy $100 billion to $1 trillion in Treasuries by the end of the year. According to Deutsche Bank however, the market has reacted as if $315 billion to $670 billion of quantitative easing has taken place recently. The Fed announced on August 10th that it would be conducting further quantitative easing this year. The stock market then had its best September in seven decades. Money printing is an easy way to juice up stock prices. And since there is an important election on November 2nd, it would make sense to think all or almost all of what is scheduled for 2010 will take place before people vote. It looks like that is exactly what is happening.

While the Fed's actions can make the stock market look good in the short-term (investors need to watch out for what follows however) and can make shorter-term rates like the two-year go down because of all of the buying that it is doing,  longer-term rates will go up if the market sees this as inflationary. The 10-year treasury is the bench mark for everything from home mortgages, to credit cards, to corporate bonds. Higher yields on the 10-year are a drag on the economy. The Fed has supposedly reinstituted quantitative easing to stimulate the economy, although there is little evidence that the Fed has managed to stimulate the economy very much in the last three years. The stimulus has instead come from massive government budget deficits. The Fed seems oblivious to the existence of a liquidity trap, a condition where increased 'money' generated from the central bank just moves around the financial system and never gets into the real economy. Under such circumstances, doing more of the same won't make things any better, but can easily make them worse.

Disclosure: No positions.

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.