The impact of Quantitative Easing on longer-term government bond yields
Posted on 19-05-2009 by Carolynn Duthie | 0 comments
Central banks have found it necessary to use non-conventional monetary policy methods in an attempt to stimulate the real macro economy. By purchasing assets, the central banks are now in a position where they can increase the wider supply of money directly.
Many had expected that quantitative easing policies would lead to lower yields on long-term nominal government bonds, as quantitative easing is an attempt to lower expectations of longer term real interest rates to stimulate demand and bring inflation back to target levels in the medium term. In the UK this hasn’t yet happened – in fact there has been a relatively strong increase in longer dated nominal bond yields since the beginning of the year. The increase has been particularly strong at maturities beyond 10 years.
Figure 1 - Government spot yield curves at end December 2008 and 17 April 2009
(Data Source: Bank of England)
You could argue that the increase in longer term nominal forward rates might be due to an increase in inflation expectations offsetting the fall in real interest rates; rational agents could link increased money supply with inflation. Market participants could simply believe that the impact of quantitative easing would be substantial inflation in the future as the central bank fail to hit its medium term target for inflation. There is, however, little evidence from the yield curves to support this!
To show this point, let’s have a look at the break down of the nominal curve into the real and inflation forward curves (Figure 2, below). At maturities up to 6 years there has been a fall in the real forward curve which has been offset by an increase in implied inflation. To the extent that the real yield curve reflects expectations about real interest rates and the implied inflation curve reflects expectations about future inflation, this would mean that inflation expectations are higher. We cannot, however, rule out the possibility that the changes in the curves reflect changes in real term premia and inflation risk premia (or technical convexity effects).
The breakdown of the nominal curve also reveals that the main explanation for the increase in the longer dated bond yields is a very strong increase in real bond yields while the increase in implied inflation had a larger impact on medium term maturities. We had been surprised about the historical low level of longer dated real government bond yields since 2003. This was a global phenomenon which Allan Greenspan dubbed as the ‘bond yield conundrum’. Does the higher real forward curve reflect higher expectations of future real interest rates? We need to be careful with such interpretation! It seems unlikely that markets expected future real interest rates to be negative at the end of December 2008. The low level of longer dated real forward rates probably reflected a negative term premium embedded in longer dated real and nominal government bond prices. A negative term premium could reflect preferred habit and/or demand-supply imbalances.
A candidate explanation for the increase in the longer dated government bonds, in an environment where many expected quantitative easing to push down on nominal and real government bond yields of all maturities, is a less negative real term premium. The preferred habitat effect in longer dated government bonds may be unwinding as the government is becoming increasingly indebted and the uncertainty surrounding its capability of servicing the debt is increasing.
Figure 2 - Instantaneous Government forward curves at end December 2008 and 17 April 2009
(Data Source: Bank of England)
Interpreting movements in yield curves is never an easy task. The changes in yield curves since the beginning of the year leave us with a number of interesting questions. Does the increase in short to medium term inflation derived from the government curve in the UK imply an increase in inflation expectations as the intervention by the government and central banks push down on short to medium term real interest rates? Could the increase in longer dated (real) government bond yields reflect the unwinding of preferred habitat effects, and negative term premia, as government debt levels become higher? The yield curve is affected by a number of demand and supply factors. Interpreting the changes in yield curves is not an easy task!
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