After the European central bank announced new bond purchases, bond prices for all major European sovereigns rose. This does not seem surprising. Fixed supply of bonds, central bank increases demand, it’s natural for prices to rise. However, if bond yields do not rise soon that would be bad news for the ECB’s goal of getting back to 2% inflation.
The U.S. experience with QE I and QE II were associated with higher bond yields. This is clear from the plot below produced by Michael Darda, chief market strategist at MKM partners.
Changes in US inflation expectations can explain the changes in the first two QE periods. Recall the long term nominal bond yield decomposition into expected future real interest rates, a term premium, and inflation expectations. Suppose we believe that real interest rates and the term premium are pinned down by productivity and preferences, and are therefore invariant to monetary policy. Then it must be that the reason the yields rose was because inflation expectations rose. Indeed, this is what inflation expectations as proxied by the 10 year TIPS breakeven suggest.
In my view, this is one of the most convincing arguments that QE “worked” in the US — the market very much believed that the asset purchases would drive up the price level. Therefore if bond yields in Europe don’t show any increase, that means the market does not expect the ECB to be successful in its crusade to raise inflation.
One might argue that this argument misses out on the liquidity effect — i.e. the fact that monetary expansions have short run effects on bond yields. Central bank cash translates into higher bids for bonds, and since there are now fewer bonds to go around, this pushes up the price. Indeed, we saw the inverse of this phenomenon during the “taper tantrum” two summers ago. After Bernanke announced the tapering off of bond purchases during the middle of the QE 3 period, 10 year bond yields had a dramatic 70 basis points rise from around 200 basis points to over 270. Contractionary policy clearly cannot raise inflation expectations, and so it’s clear that the rise in bond yields was the result of a liquidity effect.
Another argument to support the liquidity effect is that stock prices in Europe have also been rising. If the fall in bond yields reflect falling inflation expectations, that would have been very bearish for equities. The stock market rally thus contradicts the inflation expectations story.
However, the liquidity effect is a short run phenomenon. After smoothing out the market microstructure, in the end long term bond yields should still be determined by inflation expectations, expected real rates, and a term premium. So to see if the ECB’s purchases are having an effect, keep an eye out on long term bond yields and hope they go up.
Cross listed on medium.