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  Quantitative Easing and the Bond Market – How Big is the Fed’s Role? - Part 1 of 3
Posted Under: GDP • Government • Markets • Fed Reserve • Interest Rates • Bonds • Stocks
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The world can be divided into two clans these days – a dominate "Bear" clan and a minority "Optimistic" clan. The Optimists are relative optimists. For example, we see a Plow Horse economy (growing at about 2% real GDP) and an undervalued stock market that sometimes rises rapidly, but might not always do so.

The Bear clan is very pessimistic, believing the economy would still be in recession if it weren't for Quantitative Easing. They argue that QE bond buying and money printing are artificially lowering interest rates, driving all economic growth, and lifting stock prices. These Bears argue that any models showing equity prices undervalued provide "false" readings because they are based on "manipulated" market prices. According to the Bears, since QE is so massively disorienting to the financial markets, nothing is at it seems.

This Bear theory has scared many investors into believing that when the Fed "tapers" or "ends" its bond buying campaign, which it must do eventually, interest rates will rise sharply. This will, in turn, cause a massive drop in stock prices, a collapse in housing, and another recession. In other words, anything positive you thought was happening was just a mirage caused by Quantitative Easing.

But, is any of this true? We think not. As it turns out, and as can be seen in the chart above, because the Treasury has issued so much more debt than usual in recent years, the Fed's unusually large purchases of debt have kept its ownership share of Treasury bonds well within the normal range of history. In fact, the Fed held a larger share of total Treasury bonds outstanding (20%) in 2002 than it does today (18%).

Without QE, the Fed would hold a significantly lower share of debt than it has in the past. And, even if the Fed maintains QE at its current pace for the next twelve months, we estimate the Fed's share of marketable Treasury debt would rise to just 21%, slightly above the Fed's share back in 2002.

In other words, it appears that the Bears are blowing the impact of QE out of proportion when it comes to the level of interference in the Treasury bond market.

(Under the category, of "minds (great or not) think alike, but some are faster at posting than others," we want to credit Scott Grannis at Calafia Beach Pundit, a friend and terrific economist, for writing early last week on the same topic. Please feel free to catch up on his take on the topic here.)
Posted on Monday, November 25, 2013 @ 10:37 AM • Post Link Share: 
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These posts were prepared by First Trust Advisors L.P., and reflect the current opinion of the authors. They are based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
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