It is not entirely understood just how much, or even in what direction, the Federal Reserve's quantitative easing, or QE, program affected the bond market.
Simple market theory, based on increased demand from homogeneous buyers, predicts that the Fed's purchase programs suppressed bond yields below their natural market-clearing level. This assumption also suggests that bond prices were too high, given that yield and price were inverted, to the point of even creating a bubble in the bond market.
- Quantitative easing was used by the Federal Reserve from 2008 through 2014 to alleviate the financial effects of the Great Recession.
- The strategy was to buy bonds in order to suppress their prices and correct a skewed yield curve.
- Did it work? No one can say definitively.
Quantitative easing is a non-traditional approach to boosting an economy, used only when other measures fail. In the United States, the Federal Reserve employed the strategy to alleviate the financial effects of the Great Recession. Quantitative easing was employed in several rounds beginning in late 2008 and continuing periodically through late 2014. The central bank eventually accumulated $4.5 trillion in financial assets.
Quantitative Easing and Bond Prices
As noted, a campaign to suppress bond yields implies that bond prices are too high.
Operating under this assumption, traditional and conservative buy-and-hold bond strategies become riskier. In fact, both opportunity cost risks and actual default risks escalate in circumstances when bond prices are artificially high. Bondholders receive a lower return for their investments and become exposed to inflation, losing yield when they might have been better off pursuing instruments with higher upside.
Pros and Cons
This perceived risk was so strong that, during the deliberations about quantitative easing in the European Union, economists warned that artificially low government bond interest rates could compromise the underfunding condition of pension funds. They argued that diminishing returns from QE could force negative real savings rates on retirees.
Many economists and bond market analysts worry that too much QE pushes bond prices too high due to artificially low interest rates. However, all of the money creation from QE could lead to rising inflation.
The European Union has also grappled with the pros and cons of quantitative easing.
The conventional weapon used by the Federal Reserve and other central banks to fight inflation is to raise interest rates. Rising rates could cause massive losses in principal value for bondholders.
However, there are some factors at play that call into question this seemingly logical analysis. Bond buyers are not homogeneous, and the incentives to purchase bonds and other financial assets are different for the Federal Reserve than for other market participants.
Risks and Expectations
In other words, the Fed does not necessarily purchase bonds on a marginal basis, and fully backed debt obligations of the U.S. government are not exposed to the same default risks as other assets.
In addition, market expectations may be priced into the bond market ahead of time, creating a situation in which prices reflect anticipated future conditions rather than current conditions.
This can be seen in historical bond yields when yields rose for several months after the start of QE1. After the QE ended, prices rose and yields fell. This is the opposite of what many assumed would occur.
Does this prove the bond market is improved by quantitative easing? Certainly not. Circumstances never repeat in exactly the same way, and no economic policy can be evaluated in a vacuum.
It is still entirely possible that market expectations will shift again and future QE strategies will have different effects on the bond market.