Everyone is Wrong: QE Does not Lower Interest Rates

(September 2012) If you spend anytime reading or watching the mainstream media it has likely been pounded into your brain that quantitative easing (QE) lowers interest rates.  To be honest I hadn’t given the opposing view much thought until a couple of months ago.  What changed?  I read Joe Weisenthal’s piece “The Biggest Mistake People are Making about the Collapse in Interest Rates”.

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Now, we’ve had our issues with Joe in the past, but there is no doubt that he is a sharp guy.  With the FOMC meeting on tap later this week, and QE3 talk getting louder and louder, its a good time to review Joe’s piece, where he said:

….the evidence shows that QE leads to higher rates.

Here’s one of our favorite charts, from Jeff Gundlach that everyone needs to sear into their minds, which shows that rates increased each time the Fed did QE, and fell each time the Fed stopped QE.


 

So why does QE raise interest rates?

The pundits did not pull that concept that QE lowers interest rates out of thin air.  Econ 101 teaches us that if a large buyer comes and starts buying something, then without an equivalent increase in supply, the price of that something goes up.  In the case of treasuries (whose price moves in the opposite direction of interest rates) Higher prices means interest rates have fallen.
 

What is unique about this particular case is two things:

1. As the Federal Reserve buys up treasuries, they are simultaneously increasing the supply of money.  More money chasing the same amount of goods and services increases the price of those goods and services.  The market knows this, so when the Fed embarks on QE, inflation expectations increase, sending interest rates higher.

2. More money available to buy goods and services should also mean a pickup in the economy.  As people adjust their growth expectations they pull money out of super safe assets like treasuries, and put that money into riskier assets like stocks.  This is why the stock and bond market normally have a negative correlation.  When the stock market is going up the price of treasuries is normally falling, meaning interest rates are going up.
 

What’s the Bottom Line?

If the Fed does announce QE3 in this week’s meeting, investors should prepare for higher interest rates not lower, at least until QE3 is over.
 

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Comments

  1. Edward says

    “If the Fed does announce QE3 in this week’s meeting, investors should prepare for higher interest rates not lower, at least until QE3 is over.”

    oh yeah ?, what will happen if that the new QE is “open ended”…and that means we don’t know when it is going to be over.

  2. matt says

    David, I really enjoy your articles. What type of debt instruments would you recommend in light of this situation? Inflation protected, floating rate?
    Thanks.

    • davidwaring says

      Hi Matt,

      Thanks for the comment I appreciate it.

      We are not big fans of TIPS right now here’s why:

      http://www.learnbonds.com/do-tips-actually-protect-against-inflation/

      Bank Loans are floating rate and worth a look. Unless you are institutional you will need to buy them through a fund. You can learn more here:

      http://www.learnbonds.com/bank-loan-mutual-funds/

      For those concerned about inflation I think the Double Line Total Return fund is also worth a good look. There are two things which are great about this fund 1. It does not have a lot of interest rate risk meaning if rates go higher because of inflation the value of the fund will fall a lot less than many others (it has a duration of 1). 2. In today’s environment normally funds with short durations offer tiny yields of less than 1 percent. This one yields close to 7% and is absolutely crushing the competition in terms of total return.

      I like peer to peer lending as well. Also very short duration and the yields offered on P2P loans are still pretty good. Learn more here:

      http://www.learnbonds.com/investing-in-peer-to-peer-p2p-loans-from-prosper-lending-club/

      Hope that helps and let us know if there are any other questions!

      Thanks
      Dave

  3. Pam says

    I love it when economic reporters pay attention to facts instead of he-said-she-said. Unfortunately, it’s rare, especially on right-leaning sites. Thank you.

  4. techy says

    The only reason interest rates of UST will go up is others start to sell their holding, but what if everyone still wants to keep invested in UST for lower risk. I think in that scenario interest rates will go down (since more demand but same supply).

    • davidwaring says

      Hi Techy,

      Thanks for the comment. Yes you are correct if that happened then interest rates would go down. However, during QE1 and QE2 that did not happen and interest rates rose.

      Dave

    • davidwaring says

      Hi Phil,

      Thanks for the comment. That really depends on the Fed. If they want to keep the Fed funds rate at basically zero then they can regardless of what happens with QE. Where they might run into trouble however is if inflation starts to get out of control as a result but growth does not pick up. Then they are in a situation where they will probably have to raise the fed funds rate to quash inflation, which at the same time will be a negative drag on the economy.

      Either way we are still talking about higher rates not lower.

      Dave

  5. myother says

    Interest rates will go down since the banks will have more money to lend as a result of the QE. Then inflation is expected as the money the banks lend starts to purchase goods and services. Is it the inflation causes the interest rates to rise? You thoughts are welcome.

  6. Barry Rabinowitz says

    With the Fed announcing that rates will stay at Zero, at least through mid 2015, I do not see higher US Treasury interest rates. However, I do see lower rates in Yield
    Spread Assets: investment and high yield bonds, municipal bonds and dividend paying equities.

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