QE expectations vs. reality, market moves

The US Federal Reserve clearly impacts asset prices when it buys securities. But a simple study of the timing of quantitative easing announcements, the size of the Fed’s balance sheet, and the response in Treasury yields shows that market expectations of future purchases have an even greater influence than the purchases themselves. This explains why the promise of unlimited quantitative easing, or QE, is a powerful tailwind for assets and, in particular, investment grade corporate bonds.

US Treasury yields have tended to fall in the lead up to QE announcements, as one might expect. But an examination of the timing shows that official QE announcements have often occurred around the periodic low in yields, which then go on to rise as the purchases take place and the Fed’s balance sheet expands. In other words, much of the impact of QE on US Treasuries was priced in before actual purchases start. After announcements take place, the market tends to quickly anticipate a better economic environment in which the Fed’s balance sheet can be reduced.
 
This week’s Chart Room shows this pattern in recent years over several major announcements of quantitative easing. In the Covid-19 era, the Fed is trying to avoid repeating this pattern by promising unlimited QE. With no end to QE in sight for the markets to price, this should put more downward pressure on yields, whether the Fed’s balance sheet continues to expand or not.

 
 

Credit spreads, which are inversely related to government bond yields, have tended to narrow from higher-than-average levels after QE announcements. At times the threat of a smaller Fed balance sheet and subsequent rise in Treasury yields outweighed the gains in corporate credit, as we saw in 2013 and 2018. Now, those risks look to be reduced by the Fed’s unlimited QE pledge. And  with credit spreads still close to their widest levels in a decade, the case for corporate bonds starts to look appealing.

 

Reference to ($) are in US dollars unless stated otherwise.