Consider first the Fed’s share of marketable U.S. treasuries as seen in the figure below. The Fed’s treasury holdings have gone from just under $0.8 trillion in late 2007 to about $2.39 trillion as of June, 2014. Over the same time, other holders of treasuries have gone from roughly $4.4 trillion to about $10.2 trillion.
The next figure shows these same two groups in terms of cumulative change in their holdings since the beginning of 2007. Note that the Fed actually sold off a sizable portion of its treasury holdings during 2008 just as the government deficits started growing.
In total, the Fed has acquired about $1.6 trillion of treasuries compared to $5.8 trillion acquired by the other holders. The largest run up in U.S. debt history, then, was mostly funded by foreigners, financial intermediaries, and individual investors. It was not the Fed.
Now it is true that under QE3 the Fed did start to buy up more long-term treasuries, so it could still be guilty of distorting long-term yields. The figure below shows the composition of its holdings relative to the total amount (not including TIPs) as of June, 2014:
So has the Fed been ‘artificially’ pushing long-term treasury yields? Even Fed officials claim that QE works by lowering long-term interest rates. Well that was the theory and these are the facts: long-term treasury yields tended to rise during periods of treasury purchases under QE. If anything, then, QE programs raised long-term financing costs for the government.
It is particularly interesting to see the term premium fall so much between QE2 and QE3. It is as if the term premium needed QE to stay propped up. Here is one possible explanation. The QE programs increased the economic outlook and that, in turn, reduced the risk premium on other assets. Investors, therefore, were more willing to hold other higher-yielding assets and this meant they had to be compensated more to hold the low-yielding treasuries. Likewise, between QE programs, risk premiums on other assets rose and caused investors to flock back to treasuries. This migration caused the term premium to fall between QEs. In any event, this data indicates the Fed failed at lowering the term premium.
So claims of the Fed enabling the large budget deficit are not supported in the data. An alternative explanation that is that the overall increased appetite for safe assets over the past five years was the true enabler. And here is where I think the Fed is responsible. By failing to restore full employment to the economy, the Fed has allowed risk premiums to stay elevated and interest rates on safe assets to stay depressed. In fact, the 10-year treasury real risk-free interest rate (the nominal treasury yield minus expected inflation minus the term premium) closely tracks the the CBO’s output gap as seen below:
This piece is cross-posted from Macro and Other Market Musings.