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Bond market to Fed: you've got things turned around




This chart of 5-yr Treasury yields is a companion to the Vix/S&P 500 chart in my previous post. It illustrates the market's amazing reaction to the Fed's QE2 program, which was first implemented in early November. Contrary to what the Fed thought—that QE2 purchases of Treasuries would depress interest rates and thus help stimulate the economy—the beginning of QE2 marked the exact bottom for 5-yr Treasury yields, which are center-mass for the bond purchase program. It wasn't supposed to happen that way—Fed purchases were supposed to keep rates from rising, not make them rise. And since the end of January, yields have risen almost 40 bps, as better economic news has caused investors to move forward their expectations for an end to the Fed's quantitative easing efforts, and to move forward their expectations for a beginning to an eventual Fed tightening.

So the Fed had the logic and the sequence of events wrong. QE2 didn't lower interest rates, and therefore it hasn't stimulated the economy. Moreover, QE2 so far has had little discernible impact on the money supply. This leads to the conclusion that the economy was improving on its own, well before QE2 could have had any meaningful impact. Plus, this whole episode illustrates powerfully how economic fundamentals and market forces can overwhelm the efforts of mere Fed governors.

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