Fed policy debate can be summarized in a few words: to taper or not to taper. When Chairman Bernanke mentioned possible tapering (whereby the Fed would cut back on its estimated $85 billion monthly purchases of Treasury and mortgage-backed securities), the resulting bond market kerfuffle was predicated on the notion that lower or — perish the thought — no Fed asset purchases would send bond yields way up. Both a look back at the effect of past quantitative easing and a look forward to future credit market supply suggest that the concern over the effect of tapering on bond yields is overstated.
After lowering interest rates sharply to support the economy, the Fed began its first round of mortgage-backed security purchases (i.e., quantitative easing, or QE1) in late November 2008. The 10-year Treasury yield continued its steep drop from 3.1 percent to 2.1 percent in mid-December, but then gradually edged up over the next six months and nearly topped 4 percent in June 2009. Over the next year, 10-year Treasury yields ranged between 3.2 and 4 percent.
A second round of quantitative easing (QE2) began in November 2010, when the economy began to recover but the Fed was dissatisfied with the pace. The interest rate effects of QE3, which began more than a year after the end of QE2, are similar (Chart 1).
Even in the face of this explicit second and third round of market support, 10-year Treasury yields rose rather than fell. In each instance, the relative optimism about the economy and the recovery — which influences the demand for financial assets — played an important role in determining the direction of Treasury yields. Quantitative easing further supported market prices by effectively taking securities off the market (i.e., restricting supply) but did not dictate the direction of interest rates.
Looking forward, markets seem convinced that bond yields will rise when the Fed backs out of the marketplace. Maybe not.
Economic and market confidence plays a role in bond yields but so does bond supply. When people are pessimistic about the direction of the economy, they seek safe assets; when they are optimistic, they seek more risk.
The supply of safe assets, however, will also be an important determinant of future bond yields along with confidence. If the outlook about future economic activity improves, rates could go up. However, if the supply of safe assets declines at the same time, bond yields could move sideways or even go down depending on households’ and institutions’ relative demand for riskless vs. risky assets.
The supply of new issues of the safest assets, Treasury securities, is in fact slated to decrease over the next five years. A stronger economy, higher taxes and lower spending over the next several years will bring the annual increase in Treasuries sold to the public down from about $1.1 trillion in 2013 to a low of about $500 billion in 2015 before starting to move back up.
Business and mortgage borrowing is likely to rise, helping to bring total credit demand back to or possibly above current levels. Looking out to 2018, if business borrowing were to rise further and mortgages were to recover to the levels of the late 1990s (both plausible assumptions) total credit market debt would approach $2 trillion — only slightly above where it is today. In other words, the expected decline in Treasury borrowing would substantially offset a significant increase in private borrowing over the next several years (Chart 2).
In the accompanying interview, our colleague Al Wojnilower notes that the economy needs credit to grow. Given the decline in government credit demand, private credit demand needs to pick up the slack.
This shift between private and public credit demand will shift the risk profile of the financial marketplace and make safe securities like Treasuries relatively scarcer. For example, Treasuries issuance, which accounts for 75 percent of credit demand today, would account for only 25 percent in 2018. As Treasuries decline as a share of credit demand, financial market demand is likely to sustain Treasury bond prices or even drive them higher as an offset to more risky assets.
What About Mortgage Debt?
The unspoken question here is what happens to the government guarantee for mortgage debt. When Treasury credit demand declined at the end of the 1990s, financial markets turned to mortgages and the implicit guarantees of Fannie Mae and Freddie Mac as a source of safe assets.
The appetite for bonds that yielded more than Treasuries — supported by what was thought to be a federal guarantee — became insatiable and helped sow the seeds of the recent financial crisis. Now the federal support for mortgage debt is up for grabs with vocal support for and against privatizing the U.S. mortgage markets.
The U.S. investing public is not alone in demanding safe assets. There is substantial demand for U.S. Treasuries in global markets as a majority of trade and financial transactions are priced in U.S. dollars. Treasuries and other “safe” assets are an important vehicle for storing these dollars. Similarly, central banks around the world also invest their excess foreign exchange in Treasuries.
Simply put, demand for safe assets will increase and the supply of U.S. Treasuries will decline. The mortgage market, with its traditional very low default rates, is likely to pick up some of that excess demand — with or without a federal guarantee. Nevertheless, as the U.S. and global economy grow, the supply of safe assets is unlikely to meet the demand.
Could the Fed end its asset purchases without an effect on interest rates? Absolutely! A more important issue for the Fed is not the effect on the economy and/or financial asset prices from ending asset purchases, but rather the moral hazard it introduces into financial markets by continuing its asset purchases and keeping financial asset prices lower than they might otherwise be.
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