Thursday, May 30, 2013

Who Has the Ultimate Power to Set Interest Rates: Goldman Sachs or the Fed?

We'll use GS as a proxy for the primary dealers and the rest of the market participants including long-term holders.
From Calafia Beach Pundit:

QE3 proves the Fed is powerless to manipulate interest rates

If the Fed bought three quarters of the new issuance of Treasury securities over an 8-month period, with a focus on longer maturities, the 10-yr Treasury yield would almost certainly fall, right? And if the Fed bought all the new issuance of MBS over an 8-month period, increasing its share of home mortgages by over 40% in the process, yields on MBS would almost certainly fall, right?

Wrong. The Fed has indeed been a huge buyer of Treasuries and MBS since last September, but Treasury yields and MBS yields have moved significantly higher, not lower.

What we've witnessed over the past 8 months—the duration so far of the Fed's Quantitative Easing Part 3—is almost a laboratory experiment designed to discover which is the more important determinant of longer-term interest rates: the market's willingness to hold the existing stock of bonds, or the actions of a very large purchaser of bonds on the margin (i.e., the stock vs. flow argument).

It's my impression that most market participants have been persuaded by the flow argument: namely, that the Fed's massive QE3 purchases have artificially depressed market interest rates. After all, that's been the Fed's stated intention: to buy lots of bonds in order to depress interest rates and thereby stimulate borrowing and economic activity. This line of reasoning says that the fact that 10-yr Treasury yields averaged an exceptionally low 1.75% over the past year has nothing to do with the market's view of inflation or economic growth; Treasury yields have in fact become meaningless inputs to valuation models and offer no insight into market and economic fundamentals, other than as a distorting influence.

I've argued to the contrary on many occasions over the years. I believe that interest rates are determined by the market's willingness to hold the existing stock of bonds, especially since Fed purchases on the margin represent only a small fraction of the existing stock. I think the Fed can only influence yields to the extent that the market's view of the economy is similar to the Fed's. If both expect the economy to be very weak, yields will be low, and prices will behave as if Fed purchases of bonds to stimulate the economy are in fact achieving their stated objective. But if the market thinks the economy is improving and/or inflation is rising, then no amount of Fed purchases will be able to keep yields from rising. That's the situation today, and it's been unfolding (in fits and starts) almost from the day QE3 began.

Since last September, when the Fed announced it would begin buying $40 billion per month of MBS, the Fed's holdings of MBS have increased by about $330 billion, and that means the Fed has essentially purchased all of the new MBS issuance since last September. As the chart above shows, the Fed now owns over 12% of all home mortgages, up from less than 9% at the end of last September. Yet despite these massive purchases, the yields on MBS have increased by over 100 bps!...MORE