this morning we read an Bloomberg article discussing comments made by Fed Vice Chair Janet Yellen in relation to the end of Operation Twist. She said that when the program ends in June it will not amount to tightening policy (God forbid) and put forth the notion that it is the size of the balance sheet that is creating easy conditions, not the flow of purchases.
Yellen is raising a very important point that we must all be aware of in the debate between stock v flow. Essentially the debate is whether the Fed has lowered bond yields by reducing the supply of USTs (stock) or whether yields are being pushed lower by the open market purchases (flow). The Fed is operating under the belief or assumption may be a better way of saying, that it is the reduced stock of USTs that is keeping yields low. This is a very important distinction because that assumes that when Operation Twist ends in June the Fed thinks yields will continue to stay low.
The problem is we really don’t know and it’s probably a combination of stock and flow at the margin. During QE 2 and Operation Twist, the Fed has bought close to 100% equivalent of net new issuance from the Treasury, obviously representing the largest single source of demand. When that demand walks away, someone has to fill that void to absorb the supply. After QE 2 ended last year the stock market crashed so the demand came from a flight to quality. Bernanke thought the reduced stock was responsible but stocks didn’t crash, would bonds have been bid up all else equal? Tough to say.
Ultimately it doesn’t matter what the Fed believes but what the market believes. And if the Fed thinks we can get through the maturity wall of supply that is coming down the pike without some concession by the market when coupons are negative they could be in for a rude awakening. Anything can happen but we think the jury is still out and if stocks don’t crater this summer like last year it will be interesting to see who steps in to buy all this supply at negative yields.