Market Lessons From the First Round of Easy Money

As investors across the world fret over the end of the second round of quantitative easing (QE2), research firm Capital Economics has gone back to the end of QE1 to look for clues on what might happen this time.

United States Federal Reserve
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United States Federal Reserve

The market is concerned that an end to QE2 will lead to a sharp jump in Treasury yields, according to Paul Dales, a senior US economist at Capital Economics; but he is not so sure that will actually happen. Inflation expectations could fall once the Federal Reserve takes its foot off the brakes, he said.

“One school of thought is that yields are influenced by the flow of the Fed's purchases. If that were the case, once the Fed stops buying additional assets, any downward influence on yields will end,” said Dales in a research note.

Dales believes the Fed will not sell its Treasurys back to the private sector, so he expects a surge in yields once QE2 ends and is predicting they could actually fall if inflation expectations begin to fall.

"Once QE1 was completed, yields fell. And when QE2 began, they started to rise again,” said Dales. “During both QE1 and QE2, the markets' implied inflation expectations rose. And in between, they fell. So if inflation expectations were to fall once QE2 ends, then it is likely that Treasury yields will also decline."

Following the end of QE1, stock and commodity prices fell sharply as economic growth weakened and problems emerged in Europe, he said.

“The falls in Treasury yields, equities and commodity prices seen after the asset purchases under QE1 ended also coincided with a slowdown in economic activity and the beginnings of the crisis in Europe,” he wrote. “The upshot is that once QE2 is completed we wouldn't be surprised to see Treasury yields fall, particularly if inflation expectations were to drop.

"Admittedly, yields may rise if the end of QE2 prompts speculation that actual interest rates hikes are imminent. But in the current climate the Fed is unlikely to move so fast," Dales continued.

“Finally, it is possible that the upward trends in equity and commodity prices will come to a halt and the dollar will stop sliding,” he concluded.