A:

It is not entirely understood just how much, or even in what direction, the Federal Reserve's quantitative easing, or QE, program affects the bond market. Simple market theory, based on increased demand from homogeneous buyers, should predict that the Fed's purchase programs suppress bond yields below their natural market-clearing level. This assumption also suggests that bond prices are too high, given that yield and price are inverted, to the point of even creating a bubble in the bond market.

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.

This perceived risk was so strong that, during the deliberations about quantitative easing in the European Union, economists from the World Pensions Council warned that artificially low government bond interest rates could compromise the underfunding condition of pension funds. They argued that diminished 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 chief weapon 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. Some have recommended that bondholders trade their debt obligations and bond exchange-traded funds, or ETFs.

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.

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. Additionally, market expectations may be priced into the bond market ahead of time, creating a situation where 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 shift again and future QE strategies have different effects on the bond market.

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