Swedroe: The Surprising Lessons Of QE

November 05, 2014

The world didn’t end with QE, but plenty of investors were hurt because they believed it would.

On Oct. 29, the Federal Reserve announced the official end to its bond-buying program, otherwise known as quantitative easing (QE).

Given all the debate about the efficacy of the Fed’s policy decisions, and the stomach acid created by the many dire forecasts about what was going to happen when quantitative easing ended, I thought it worthwhile to review the historical record and determine if there are any investment lessons to be learned.

Prior to the financial crisis of 2008, the Fed held between $700 billion and $800 billion in Treasury notes on its balance sheet. In late November 2008, the Fed began its QE program, announcing it would buy $600 billion in mortgage-backed securities (MBS).

By June 2009, it held $1.75 trillion in bank debt, MBS and Treasury notes. And by June 2010, its balance sheet had grown to $2.1 trillion. Further purchases were halted because the economy had started to improve.

QE Round Two

Having come to the conclusion that the economy wasn’t growing fast enough, in November 2010, the Fed announced its second round of quantitative easing (QE2). By the end of the second quarter of 2011, it had purchased more than $600 billion in Treasury securities.

Still not satisfied with the rate of economic growth, a third round of quantitative easing (QE3) was announced in September 2012. The Fed said it would buy $40 billion in MBS a month. It expanded its purchases in December 2012 saying it would also buy $45 billion in Treasury bonds a month.

In December 2013, the Fed announced it would begin to phase out (or taper) the program in January 2014, reducing the amount of its purchases by $10 billion each month. As a result of all these bond-buying programs, the Fed’s balance sheet has grown to about $4.5 trillion.

 

Self-Questioning

Ever since the Fed began its policy of QE, there has been an ongoing—and often heated—debate as to whether the Fed was doing the right thing. Many warned that the expansion of the Fed’s balance sheet would lead to a dramatic rise in inflation. After the announcement of QE2, a group of 43 economists published an open letter to then-Fed Chairman Ben Bernanke.

They wrote that the program should be “reconsidered and discontinued.” The planned bond purchases, they said, “risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.”

At the time, many bond forecasters had also made dire predictions about interest rates. They warned investors to buy only short-term bonds because rates were sure to rise and the dollar would fall sharply, perhaps even losing its status as the world’s reserve currency. Such predictions boded ill for the stock market as well.

For example, in March 2011, the 10-year Treasury note was yielding about 3.4 percent. The former “bond king” Bill Gross announced that PIMCO had removed government debt from its flagship fund (PTTRX), arguing that bond levels were unsustainably low given the scale of government debt obligations and the Fed’s quantitative easing program.

Many others were predicting that QE3 would lead to soaring gold prices. How did those forecasts turn out?

Forecasts Versus Reality

At the end of November 2010, the 10-year Treasury yield was about 2.9 percent. As I write this on Oct. 30, 2014, the 10-year yield stands at just 2.3 percent. Strike one.

The inflation rate in 2011 did rise to 3.0 percent. However, in 2012, it fell back to just 1.7 percent. In 2013, it fell further, to 1.5 percent. And the Consumer Price Index rose just 1.7 percent for the first nine months of 2014.

Not only have we not seen rising inflation, but expectations for future inflation are tame. We can observe that in the breakeven rate of inflation between Treasury inflation-protected securities (TIPS) and nominal bonds as well as in economists’ forecasts.

The current breakeven rate between 10-year nominal bonds, which are yielding about 2.3 percent, and 10-year TIPS, which are yielding about 0.4 percent, is just 1.9 percent.

Clearly, the market is not expecting rapid inflation. And the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters has a 10-year inflation forecast of just 2.2 percent. Strike two.

As to the value of the dollar, at the end of November 2010, the Fed showed the trade-weighted value of the dollar at about 100. As of Oct. 22, the Fed showed that its value was just below 106. Strike three.

 

More Faulty Forecasts

The unemployment rate also ignored the forecasts of those 43 economists. It fell from 9.8 percent in November 2010 to its current level of 5.9 percent. Strike four.

Forecasts by gold bugs didn’t turn out to be correct either. For instance, Peter Schiff has talked about the possibility of gold hitting $5,000 an ounce or higher since at least 2011, when prices for the metal topped $1,900 in intraday trading.

Not only has the dollar risen, with inflation under control and interest rates down slightly, gold actually has fallen from its November 2010 close of $1,384 to about $1,200 currently. Compare that with the return to stocks over the same period. The S&P 500 index closed November 2010 at 1,180. On Oct. 29, 2014, it closed at 1,982.

Even on a price-only basis (the index doesn’t include the return from dividends) that’s an increase of 68 percent. Adding in the dividend return, the gain is in excess of 75 percent. That’s five strikes.

Yes, 100% Of Economists Got It Wrong

The following should be an enlightening tale.

Each month, Bloomberg surveys economists to ask them about the direction of interest rates. In January, 97 percent of the economists surveyed said they expected interest rates to rise within the next six months. In February, 95 percent had that expectation. In March, the figure was back up to 97 percent.

With the yield on the 10-year Treasury note at 2.7 percent, the April survey showed that 100 percent of the 67 economists surveyed expected interest rates to rise within the next six months. Yes, 100 percent of them were wrong.

That so many economists were so wrong shouldn’t come as a surprise.

Faulty Forecasting: A Way Of Life

There’s a wealth of research showing that when it comes to financial markets, there really aren’t any good forecasters. For those interested in the evidence on the ability to forecast accurately, I recommend “Expert Political Judgment” by Philip Tetlock and “The Fortune Sellers” by William Sherden.

On an amusing note, Tetlock did find that the only thing correlated with forecasting accuracy is fame, and that correlation is negative. The more famous the forecaster, the less accurate the forecast.

It’s important to remember that, while the Fed’s actions created the risks highlighted in many of the forecasts, few events ever occur with anything close to the certainty often expressed by ever-confident “gurus.” Confidence, like in the case of the aforementioned Peter Schiff, is no substitute for accuracy.

 

Ignore Forecasts

Hopefully, the lesson you take away from this discussion is that the winning strategy is to just ignore all such forecasts and adhere to your well-thought-out financial plan.

If you have trouble ignoring forecasters, it might help to remember this pertinent advice from Warren Buffett: “We have long felt that the only value of stock forecasters is to make fortune-tellers look good. Even now, Charlie (Munger) and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”

He also provided investors with this warning, from Berkshire’s 2013 annual letter to shareholders: “Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous.”

What To Do Now?

The end of the Fed’s QE program does not mean bond investors are better off staying in cash or in very-short-term investments. Such a conclusion fails to consider that the current yield curve already reflects the expectation that interest rates are going to rise. Thus, for bond investors to actually lose money, interest rates must rise faster than already implied by the current yield curve.

The historical evidence demonstrates that efforts to outguess the bond market are highly unlikely to be productive. Standard & Poor’s twice-yearly Active Versus Passive (SPIVA) scorecard regularly demonstrates that active bond managers fail miserably — even worse than active stock managers —at beating their benchmarks.

That certainly has been the case for bond bears over the past half-decade. About six years ago, at the end of October 2008, the 10-year bond was yielding 4.0 percent.

The investors who followed the advice of forecasters calling for rising rates likely missed out on a large bond rally. They were stuck earning almost no return and have yet to be proven correct.

More History Lessons

If you’re still tempted to listen to the warnings of market “gurus,” consider the historical evidence from prior episodes of quantitative easing. In the 1990s, Sweden’s central bank, the Riksbank, more than doubled that country's monetary base during the Nordic banking crisis. Inflation there remained moderate both during and after the expansionary period.

Even as the monetary base jumped, from 1994 to late 1996, inflation did not follow suit. In fact, it remained flat before falling in 1996.

And Sweden was not an isolated case. The Federal Reserve Bank of St. Louis examined expansionary periods over the last two decades in the U.K., Switzerland, Japan, Australia, New Zealand and Iceland.

Fed researchers concluded that quantitative easing is a useful policy tool and that doubling or tripling a country's monetary base doesn’t lead to high inflation if the public views the increase as temporary and expects the central bank to maintain a low-inflation policy.

 

Imagined Risks Vs. Real Risks

In fact, they found little increased inflation impact from such expansions. They also noted that the key to successfully implementing a policy of QE is, when the crisis has passed, for the Fed to promptly unwind its balance sheet.

That does mean extending maturities isn’t without risk. But if you recall, the pricing of that risk is embedded in today’s yield curve.

My crystal ball, as always, is cloudy. So I don’t know if or when the Fed will be able to successfully unwind its balance sheet at the right time. In other words, I know what I don’t know.

Forecasters either don’t know that they don’t know or they are getting paid a lot of money to pretend they do. With that said, we do know quantitative easing has occurred without triggering high inflation. We also know the Fed is well aware of the risks of failing to remove that stimulus in a timely fashion. The market reminds them of it on an almost daily basis.

Ignore The Noise

We also know that investors who have been scared by all the media attention, and thus altered their investment plans to avoid term risk, have paid a steep price for trying to dodge it. As always, the winning strategy is to ignore the noise of the market and stick to your well-developed financial plan, one that already incorporates the risks of unexpected inflation.

It’s important to keep these facts in mind as you consider what to do with your bond portfolio. Yes, it’s true that if the economy does eventually recover, bond yields will have to rise. But it was fear that the Fed might begin tapering off its QE program sooner and more quickly than previously thought that led to a sharp sell-off in bonds after Bernanke’s speech on June 19, 2013.

The yield on the 10-year Treasury has jumped from 2.20 percent to about 2.50 percent since then. The CBO’s “baseline” forecast assumes a slow but steady rise in 10-year Treasury rates—about a tenth of a percentage point per quarter, to an average of 4.1 percent for all of 2016.


Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.


 

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