Quantitative Easing and the Bond Market

Of all the markets in the world that are being affected by the policy of quantitative easing (QE) tapering, the bond markets are the most affected. This is because the policy rules mandate that the primary investments being made by the government as a result of the money created must be in the bond markets.

As a result, a massive amount of money is entering and leaving the bond market based on the changes in this policy.

In this article, we will have a closer look at the effects of both quantitative easing (QE) as well as quantitative easing (QE) tapering on the bond market.

Effects of Quantitative Easing

Quantitative easing (QE) has many effects on the market. The foremost ones which have the highest impact have been listed in this article.

• Increased Demand: The bond markets around the world and particularly the ones in the US and Europe face the most direct impact of the quantitative easing (QE) policies being launched by governments across the world. This is because quantitative easing (QE), by definition, refers to the buying of government bonds with money that has been newly created by the Central Banks.

  Hence, the banks are in effect creating new money and pumping it into the system. Therefore, the demand for bonds that absorb this newly created money is bound to rise. It is for this reason that the quantitative easing (QE) money is used to buy only government bonds ensuring that no private parties make any profits as a result of this government policy.

  The US government is thus said to be having an easier time financing its $2 billion per day debt requirement, thanks to the quantitative easing (QE) policy that it has introduced.

• Bubble: When a huge amount of investments are legally designated for a single asset class, there is bound to be some sort of bubble creation. For instance, the government bonds are the only asset class wherein banks can invest their newly created money.

  Hence, the governments have to issue more bonds and banks have to print more money to keep the system running. As such, the true financing costs of the bonds are hidden. This is because when a lot of buyers chase a limited amount of bonds, the yield of the bonds remains less. The governments can afford to give less interest and still sell their bonds because of the increased competition amongst investors.

• Speculation: The policy of quantitative easing (QE) has also led to the creation of a lot of speculative activity in the bond market.

  Ideally the bond market is supposed to move based on the fundamentals which are dictated by interest rate changes. Interest rate changes are small and do not move much overnight. Hence, bond markets were once considered safe havens for investments. Debt investments would make smaller but fixed returns.

However, in the recent past, the bond market is being driven single handedly by expectations regarding the quantitative easing (QE) policy.

The interest rates have literally taken a backseat wherein quantitative easing (QE) is running the show. Now, the quantitative easing (QE) policy is highly unpredictable. As a result, the bond markets fluctuate wildly before any major announcements by the Fed, European Central Bank (ECB) or any other authority.

Effects of QE Tapering

Like quantitative easing (QE), quantitative easing (QE) tapering also has many effects on the market. Some of the major effects of quantitative easing (QE) tapering are as follows:

• Decreased Demand: The policy of quantitative easing (QE) tapering has a completely reverse effect as compared to quantitative easing (QE). Whereas quantitative easing (QE) prompted the investors to pump in more and more money in the government bond markets because of legal compulsion, the policy of quantitative easing (QE) tapering does the exact opposite. As the news spreads that the government is not going to print any more money and invest in the market, people begin to withdraw their investments from the bond market and use the proceeds to invest in another market. The fundamentals of the market may have remained unchanged but an announcement of quantitative easing (QE) tapering is enough to create a significant dent in the market.

• Yields Rise: The policy of quantitative easing (QE) in a way subsidizes the cost of issuing bonds for the government. It does so by creating excess demand which creates competition amongst investors. When the policy of quantitative easing (QE) tapering is implemented, the exact opposite happens. This means that the investors leave the markets in huge numbers. As such the yields suddenly spike up causing the prices of the bonds to soar exponentially.

• Bubble Burst: Thus, the policy of quantitative easing (QE) leads to the creation of a bubble whereas the policy of quantitative easing (QE) tapering leads to the bursting of that very same bubble. The bonds have an intrinsic value of let’s say X dollars. During the quantitative easing (QE) period, excess demand raises the value to X+5 dollars and sustains it there further perpetuating the bubble. When quantitative easing (QE) tapering is implemented, the value drops to X-5 dollars. Hence, the stability of the bond markets is jeopardized by the booms and busts created by the quantitative easing (QE) policy.