The Implications of Fed QE2 for Client Portfolios

Wednesday’s announcement that the Fed will be buying hundreds of billions of dollars in U.S. Treasury securities is anything but a surprise. Fed Chairman Ben Bernanke initially mentioned the idea back in early August and has been discussing it publicly ever since.

The program, known as quantitative easing (or QE2, because this is the second round of easing since the crash of 2008), has two objectives, both of which are intended to boost the sputtering U.S. economic recovery. First, buying long-dated Treasuries in large quantities decreases long-term interest rates by artificially raising prices and reducing yields. Second, the program increases liquidity in the financial system because the money that the Fed spends buying the securities will be transferred directly to private institutions that can turn around and lend it back into the economy.

There are three main implications of QE2.

1) The Near-Term Implications

Regardless of how you feel about the merits of the policy—it’s a bold, complex plan with plenty of supporters as well as detractors—it’s important to understand its near-term implications for your clients’ portfolios. Predicting future interest rates is impossible, of course, but given the scope of this policy it’s reasonable to expect that the yield curve will stay near or below its current level for at least a little while longer.

Thus, for investors currently holding fixed income securities (including individual bonds, mutual funds, and/or ETFs), QE2 will most likely preserve current valuations

or possibly even provide some short-term gains.

But for investors looking to put new capital to work in fixed income in the near-term, QE2 won’t make it any easier. The policy is explicitly designed to keep rates low so that borrowers can obtain credit cheaply, so finding bonds with attractive yields will require some effort. (Note that the BondDesk monthly Market Transparency Report provides a detailed snapshot of corporate yields you can use to help identify opportunities in the market.)

2) The Past Implications

It is also worthwhile to understand the impact that QE2 has already had on your clients’ portfolios, almost a full three months before it went into effect. The initial announcement by Mr. Bernanke immediately triggered a massive Treasury rally at the long end of the curve. Yields on the 10-year while 30-year bonds fell precipitously in August and (except for a couple of bullish weeks in early September) continued to drift down until mid-October.

But for reasons that aren’t completely clear, things changed in mid-October. Notably, 30-year rates increased substantially, closing above 4.0% for the first time since before the August announcement. The yields on 10-years also increased, though not quite as dramatically. One explanation is that institutional investors decided that yields had overcorrected in anticipation of QE2, so they sold their positions before rates turned around.