Have yields stopped listening to economic releases? ......

I came across this very interesting graph this morning. In normal times and circumstances (whatever that may mean), bond yields are heavily influenced by how weak or strong the economies prospects are perceived to be. In the graph, the white line is the Citi economic surprise index, which is an index that shows the deviation of actual economic releases in comparison to the expectations. Clearly, the index has had a very strong move up in the latter half of the year, as US economic releases have generally been stronger than expectations. In the past, the yield (the 10 year - orange in the graph) would have moved up in tandem, as a better than perceived economy would have led to a movement from the fixed income market (lower prices higher yield) into the equity market.
But times are far from normal. Markets are absolutely terrified of PIIGS defaults. Thus despite stronger news emanating from the US, the awful news out of Europe has seen the Treasuries retain an unprecedented demand for the "perceived" safe haven status.

Surely though in unveiling Operation Twist, whereby the Fed is aggressively buying long dated bonds (to keep the yields low) and selling shorter dated bonds, that has been the determinant in keeping lower yields? I'm not so sure. If for some reason, somehow, the market became convinced that Europe was turning the corner, and that there was light at the end of the tunnel, wouldn't the yields be expected to rocket higher, Fed or no Fed?

Yields are at all time lows- yields are pricing in the risk that the market may not exist in a recognisable form in the not too distant future, with fears of defaults and a collapse of the financial system.

So what is QE?

Many are under the impression that with the end of the Fed's Treasury purchases, the Fed will not be pumping more money into the economy and that constitutes a monetary "tightening". I believe that this way of thinking is incorrect. As interest rates were lowered, monetary conditions could adequately be described as "loosening". As the Fed continued to keep the interest rate at a very low level, the policy could aptly be described as a continued easy monetary policy.

However, it is at this point that the Fed embarked on their quantitative easing policy. The traditional rate cutting had already taken its course, and then the Fed started pumping the additional liquidity. Hence the cessation of the Treasury purchases by the Fed, would not be described as the end of easy money. Interest rates are at historic lows, and monetary tightening will not begin until the Fed starts unloading its balance sheet.

Another misconception is as to the way QE helps the economy. Fed buys treasuries, the extra money finds its way into the economy. Yes? NO. The Fed purchases Treasuries from a dealer, whose ability to then make other purchases allowing the additional money to finds its way into the economy has practically no bearing on the extra "money" from the Fed. If the dealer wished to purchase additional oil futures, or stock futures, he could do so with very little margin. The transaction from the Fed has no effect.

What it does do is it increases the monetary base, and through the money creation effect, this has the ability to add new money through additional bank lending. With the current reserve requirement 10%, $600 billion has the potential to add $6 trillion in new money. However, either because the banks have been so pre-occupied in repairing their own balance sheets, or the public has not been willing to take on bank loans due to the vulnerability of the economy, the banks have not been lending the extra potential money into the economy.

Foreign holdings of US Treasuries declines by 2nd largest amount EVER

The US balance sheet hit a new record last week, a mere $2.779 trillion. Most worryingly is that the Treasury securities held in custodial accounts at the Fed, which is considered to be the best representation of real time foreign holdings of US treasuries, fell by the largest amount in 4 years, the 2nd largest decline in history. It was topped only by the decline of the week ending 15th August 2007, which is when the world was ending!

-------------------------------------------------------------------------------------------------LEGAL DISCLAIMER: The views mentioned above are purely that of the author, and does not necessarily reflect the official view of Goldrock Capital or employees. Unless of course the aforementioned view was a phenomenally good call, with exquisite market timing, in which case Goldrock Capital reserves the right to all credit!!!!!