"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Tuesday, September 7, 2010

Scott Sumner and long term interest rates

Scott Sumner writes:
"I predicted that aggressive QE would raise long term interest rates, a view which seemed to be refuted by the response on T-bond yields to the March 2009 Fed QE announcement. <..>

Any effective monetary stimulus would be expected to raise long term rates. We have plenty of examples of that occurring. My favorite is the surprise stimulus announcement of January 3, 2001, which caused long term (nominal) rates to soar. Thus I was shocked to see long term rates fall sharply on the day of the March 2009 QE announcement.

I don’t have a good theory for why that happened. One could point to the fact that they quickly reversed, and soon rose far above the pre-announcement level. So maybe markets made a mistake and I was right all along. But that means the EMH is wrong, a theory I hold even more dearly. So either way I’m screwed.

If I had to guess I’d say it might have something to do with the type of stimulus. It didn’t so much raise the monetary base (indeed the Fed was correct in denying that it really was QE) rather it changed the composition of their balance sheet. Even so, other markets (stocks, foreign exchange) reacted as if it was bona fide monetary stimulus. So I am not really satisfied with that explanation either.

I am reluctant to form a firm opinion based on a single observation, so I will watch market reactions to other QE-type actions, to see if a pattern develops. If I was forced to critique my own blog, the market response to the Fed’s March 2009 “QE” would be my number one weapon."

As Krugman reminds us, EMH is false. Arbitrage capital was very expensive in March 2009, and treasury market, one of the most liquid and important markets in the world, was more inefficient than normally. Here is a must-see video that shows the term structure of interest rates over the recent past, degradation of market efficiency is clearly visible with the naked eye.

March 2009 QE announcement was an effective monetary stimulus, as real risk assets rallied. The Fed said it will perform Treasury-Agency bond arbitrage, expectation of such arbitrage has made Treasuries more attractive for some investors who were previously holding Agencies. These investors (with inflexible investment mandates) created buying pressure that overwhelmed the actions of those speculators who are sensitive to macro developments, and markets made a mistake.

Related posts: Krugman and the bond bubble

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