The Unwinding of QE Has Begun

Don't look now, but the Fed is quietly unwinding QE. As seen in the figure below, the Fed's share of marketable treasuries has been shrinking:

To be clear, this is a passive unwinding of QE. The Fed's treasury holdings have not changed, but the stock of marketable treasuries has grown. Nonetheless, this is still an unwinding according to the portfolio channel of monetary policy. This channel says the Fed's taking of safe treasury assets from the public would force investors to rebalance their portfolios toward riskier assets. This rebalancing, in turn, would reduce risk premiums, lower interest rates, push up asset prices, and help shore up the recovery.

Now the portfolio channel should be working in reverse. The public is getting a larger share of treasuries relative to the Fed thanks to the ongoing budget deficits. Moreover, this passive unwinding by the Fed is being reinforced by other central banks according to CNN Money:

In the first six months of this year, foreign central banks sold a net $192 billion of U.S. Treasury bonds, more than double the pace in the same period last year, when they sold $83 billion. 

China, Japan, France, Brazil and Colombia led the pack of countries dumping U.S. debt. It's the largest selloff of U.S. debt since at least 1978, according to Treasury Department data. 

"Net selling of U.S. notes and bonds year to date thru June is historic," says Peter Boockvar, chief market analyst at the Lindsey Group, an investing firm in Virginia.

So have all these central bank actions caused U.S. treasury yields to take off? Have the Bill Grosses of the world finally vindicated themselves? The answer is no. Treasury yields continue to remain at historic lows despite the unloading of treasuries by central banks. How can that be? Here is CNN again with the answer:

Despite all the selling by these countries, private demand for the bonds has sky rocketed. Demand is so high that the U.S. can afford to pay historically low interest rates. The 10-year U.S. Treasury hit a record low of 1.34% earlier this year, before bouncing back to about 1.58%, currently.

In other words, central banks have not been very important in shaping the path of long-term treasury yields. You, me, and our financial intermediaries, on the other hand, have been a key reason for the decline of U.S. treasury yields to historic lows. While not the only factor, our seemingly insatiable desire for safe assets has been a pivotal factor behind the low interest rates. And, as can be seen in the figure below, the decline in safe asset yields is a global phenomenon:

This is the safe asset shortage problem. As seen in the figure, the trend in safe asset yields turned down in 2008. This common change in trend should reinforce the point above that this is not a consequence of central bank's actions. Instead, as outlined here, the safe asset shortage problem is the consequence of a reduction in the supply of safe assets, an increase in demand for them, and an ongoing spate of bad economic news that keeps this economic sore from naturally healing. 

The failure of treasury yields to rise with the unwinding of QE is just another data point that confirms this understanding. Here's hoping the Bill Grosses of the world take note.