Tuesday, January 4, 2011

A graphical illustration of quantitative easing & the bond market rejection

On November 3, 2010 the F.O.M.C. announced that it would be purchasing 600 billion in treasuries on a schedule of $75 billion a month till the second quarter of 2011.  When the Fed does quantitative easing it is mostly just purchasing 2 to 10 year nominal U.S. treasury bonds.  The main channel through which quantitative easing is supposed to work is called the portfolio effect.  This works as follows, the Fed purchases treasuries therefore reducing the total supply on the open market.  The supply curve for treasuries in figure 1 shifts to the left from BS0 to BS1 as we move from A to B. Notice that their yield or the interest rate return falls from R0 to R1.  The fall in this interest rate causes investors to seek higher returns in assets with comparable maturities and interest rate risk structure.  A 10 year AAA corporate bonds yield would then be more attractive relative to 10 yr nominal treasuries and their demand curve in figure 2 would shift right from DCB0 to DCB1.  The lower interest rate on these corporate bonds would make it easier for firms with access to the capital markets to issue debt for long term business investment.

It is now January 4th, 2011 and we wish to see if the fed’s plan to spur long term investment is doing what the portfolio effect would suggest.  Figure A is the same as before with the fed reducing the total available supply of treasuries on the market. 

Figure B & C: The bond market rejects the purchases so the demand for treasuries shifts to the left from BD0 to BD1 and we move from point B to point C in figure B.  The Feds actions are completely negated in the treasury market.  Since AAA rated corporate bonds are closely tied to treasuries, the portfolio effect has also worked the other way.  This was witnessed when the demand for corporate bonds shifted to the left.  This is represented in figure C with the movement from A to B and a higher interest rate as the demand curve shifted from DCB0 to DCB1.  The higher interest rate discourages debt issuance for the support of long term investment.

As one can see from the following chart, this is exactly what occurred.  The bond market rejected the fed’s actions and started a massive sell off which lead to the steepening of the yield curve.
The following figure D, wraps up the story.  With the Fed agreeing to purchase 600 billion more treasuries, people may be feeling that bonds are overpriced and decided to take their money elsewhere, mainly the stock market.  The less risk adverse attitude and hope for a higher return led people to dump their bonds and buy other assets like equities.  The demand for equities in the diagram below shifts to the right from D0 to D1 as it moves from point A to B. 

The following chart describes that this is exactly what happened as the yield curve steepened so did the S&P rage.


  1. Good information on the basis of graphs and charts and their increase the supply of money by increasing the excess reserves of the banking system, generally through buying of the central government's own bonds to stabilize or raise their prices and thereby lower long-term interest rates.