Since the banking crisis of 2008, neither fiscal nor monetary policy has proved up to the task of rejuvenating the US economy. The Federal Reserve, in particular, has explored almost every tool in its arsenal to increase economic growth. In 2009, there was Quantitative Easing II (QE II), where an influx of $ 600 billion was used to buy long-term bonds and lower long term interest rates. Those lower rates, it was argued, would help get housing back on track and increase real economic growth. At the time, I argued (though I admitted my limited credentials to be involved in this debate) that I did not think it would work, for the simple reason that interest rates were already low, with the 10-year T. Bond rate at 3.3%.
Two years later, the 10-year T. Bond rate stands at 2.09% and treasury bill rates are close to zero. The Fed is now planning to get back into the game with a maneuver that it has last tried in 1961: Operation Twist. Simply put, here is what the Fed hopes to do. Rather than introduce more funds into the system (like QE2 did), Operation Twist is a shift in what securities the Fed invests in, rather than how much. The Fed, which holds about $1.7 trillion of US treasuries is planning of reducing its purchases of short term treasuries (1 month, 3 month etc.) and increasing its holdings of long term treasuries (10 years and higher). Assuming that the rest of the market stays in a holding pattern, the increased demand for long term bonds should lower those rates, while the rate for the short term notes and bills will increase.
Now, let’s look at the why. There seem to be three stories offered: an “interest rate” story, where real growth will increase as a consequence of this maneuver, a “confidence” story, where US companies and consumers will be heartened by the Fed’s activism and and a “valuation” story, where stock prices will react favorably to the shift in the term structure:
- The “interest rate” story goes as follows. There are a number of key consumer (mortgage financing) and corporate interest rates (corporate bonds, long term bank loans) that are tied to the long term rate. In its optimistic version, for consumers, QE3 will reduce the rates on mortgages, inducing those staying on the sidelines to either borrow and buy a new house or to refinance an existing house at the lower rate, with the savings going into consumption. Companies, it is argued, will also be more likely to borrow more, if corporate bond rates decrease, and make new capital investments.
- The “confidence” story is based upon the presumption that both producers and consumers in the United States prefer a Fed that acts to one that does not. Since QE3 would qualify as action, both groups, it is argued, will become more inclined to invest, consume and take risks.
- The valuation story builds on the first two. Here is what the optimistic take is: a lower long term rate will trump higher short term rates, pushing discount rates down. The higher real growth, coming from the interest rate story, and lower risk premiums, emanating from the confidence story, will then augment this impact, causing stock prices to increase even more.
- For the interest rate story to work, long-term interest rates have to go down significantly without short term rates shooting up too much. In the figure below, I have the yield curve in September 2011. If the 10-year bond rate is at 2%, how much lower can it go? Even the optimists at the Fed seem to foresee a drop of about 20 basis points as the outcome and no one seems to have an estimate on the concurrent increase in short term rates. Since mortgage rates are already at historic lows, I don’t see a further drop of 0.20% making much difference.
- I don’t buy the confidence story, simply because I don’t think action always trumps inaction. In fact, my reaction to hearing that the Fed was trying to twist the yield curve is that they must be scraping the bottom of the barrel, if this is the best that they can do.
- Finally, the valuation story. Does the level of interest rates affect stock prices? Of course! Does the slope of the yield curve matter for equities? Also, yes! One way to see this is to look at the Earnings to Price (EP) ratio (the inverse of the PE ratio) for the S&P 500 (using trailing earnings) in relationship to the 10-year T. bond rate (measuring the level of rates) and the difference between the 10-year rate and the T.Bill rate (measuring the slope of the yield curve) from 1960-2010. Regressing the EP ratio against the ten-year rate and the yield spread differential (with t statistics in brackets):
EP = 2.66% + 0.67 Ten-year T.Bond rate - 0.31% (T.Bond rate - 3 month T.Bill rate)
(3.37) (6.41) (1.36)
How would I read this? At least between 1960 and 2010, every 1% increase in the long term bond rate increases the EP rate by 0.67% and every 1% increase in the slope of the yield curve decreases the EP ratio by 0.31%.