S&P achieves what QE2 could not - lower bond yields

By Arjun Parthasarathy

Standard & Poors’ downgrade of the US credit rating has benefited US treasury yields the most. At one stroke, S&P has brought down yields on the 10-year treasury by 60 basis points (100 basis points make 1 percent).

The 10-year yields are now trading at their lowest levels seen since December 2008. The US yield curve too has flattened by 60 basis points (bps) on the back of the S&P move. The two-over-ten treasury spread has come off from 260 bps to 200 bps since the downgrade.

US bond yields are clearly factoring a period of low inflation and low growth. The US Federal Reserve (Fed) has pledged to keep rates at 0-0.25 percent till mid-2013 on the back of a perceived weakness in the US economy.

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The Fed saw weakness in the US economic recovery in mid-2010 and embarked on a $600 billion government bond purchase programme (QE2) to bring down long-term rates to take the economy out of the woods. The Fed bought long-dated US treasuries from November 2010 to June 2011 in order to bring down yields and pump in liquidity into the system.

[caption id=“attachment_60419” align=“alignleft” width=“380” caption=“The Fed bought long-dated US treasuries from November 2010 to June 2011 in order to bring down yields and pump in liquidity into the system. Mladen Antonov/AFP”]  [/caption]

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But the Fed’s bond purchase had the opposite effect on long bond yields. Bond yields moved up by 100 bps from the time the Fed started bond purchases.

The effect QE2 had was to raise inflation expectations due to the Fed’s printing of money. Bond yields in the US started trending down from May 2011, when doubts over the economic recovery cropped up. The stagnation of the unemployment rate at 9.2 levels, revision of the 2011 GDP forecast by the Fed from 3.1-3.3 percent to 2.7-2.9 percent and worries over the growth in the eurozone due its debt problems, started taking down bond yields. The fact that the Fed ended the QE2 in June and did not announce a fresh one took its toll on growth expectations.

The US government too contributed to the decline in bond yields by haggling over the increase in debt ceiling. The debt ceiling bill was passed one day before a bond repayment date. Then came the S&P downgrade from AAA to AA+. S&P cited insufficient cuts in the fiscal deficit as the reason for the downgrade.

US 10-year yields are at three-year lows of 2.18 percent and, given the current reading of the US economy by the Fed (low growth, low inflation), the 10-year bond yield is likely to decline further. The Fed tried to achieve this effect by printing money to buy long dated US treasuries and failed. The QE2 did not have a long-term effect on the US economy, as seen by the revision in GDP growth forecasts. Hence the efficacy of quantitative easing is questionable.

The fall in long bond yields will have positive effects down the line. Borrowing costs come down for mortgages as well as for long gestation project finance. If inflation stays well below targets for a while, the Fed need not do anything except keep rates at all-time lows and maintain sufficient liquidity for the economy’s needs. Embarking on a QE3 is not a solution, especially if it takes up long bond yields.

S&P has done the US a favour though policy-makers there think otherwise!

Arjun Parthasarathy edits www.investorsareidiots.com