What's Going On With QE2?

Yields have been steadily rising since the Fed’s announcement in early November.

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By now, you've probably heard that the Fed is purchasing $600 billion in treasuries in hopes that it will push interest rates even lower, spur lending, and help jump-start the economy. Two years ago, the Fed set the federal funds rate (the interest rate at which banks lend to each other) to virtually zero, and this second round of quantitative easing—commonly referred to as QE2—is one of the few tools it has left to help boost economic growth. In spite of all this, a funny thing has happened. Treasury yields have actually risen since the Fed's announcement.

On November 4, the day of the Fed's official QE2 announcement, the yield on the 10-year treasury was 2.5 percent. Now it's hovering around 3 percent. Does this mean the Fed's program isn't working? To really understand what's going on with yields, you have to examine a host of other factors, including another wave of debt concerns in Europe. Here are a few explanations for what's happening in the bond market:

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Too early to tell. It hasn't even been a month since the Fed's announcement. The Fed said it would inject the $600 billion over a period of eight months. That means we're only about one-eighth of the way through, says Stacey Schreft, former vice president and economist at the Fed. "It's definitely not a failure, and it's way too soon to conclude that it would be even if one could conclude that," says Schreft, who is currently the director of investment strategy at the Mutual Fund Store, an investment management firm.

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Buy on the rumor, sell on the news. Back in August, Fed chair Ben Bernanke hinted that the Fed would pursue a second round of easing. (The first round came in early 2009.) "The amazing thing about Fed policy is the impact that Fed announcements have," Schreft says. From August 27 (the day of the Fed's meeting in Jackson Hole, Wyo.) through November 4, the 10-year treasury yield fell 13 basis points, from 2.66 to 2.53 percent. Leading up to the announcement, the markets anticipated the Fed's move and yields fell in advance of the actual program launch. Such an occurrence is often referred to as "buy on the rumor, sell on the news," in which investors make their move before a market-moving event actually happens. Schreft argues that in a way, the program has been working since the end of August, and that the economy is better off than it would have been without the Fed's announcement.

[See Why More Quantitative Easing Could Be a Mistake.]

Yields are lower than they would have been. Experts say QE2 can't be viewed in isolation. "All other things equal, [QE2 is] presumably pushing the prices of treasuries up and the yields of treasuries down relative to where they would have been otherwise," says Robert Tipp, chief investment strategist for Prudential Fixed Income. No one was certain whether or when the European debt crisis would reappear, but now it has. Ireland is the new focus. Generally, when there is trouble overseas, investors flock to treasuries because they're considered one of the least risky investments available. That's because they're backed by the full faith and credit of the U.S. government, which has never defaulted on its debt. One reason the Fed pursued a second round of easing was to push investors out of virtually risk-free investments like treasuries into riskier asset classes like corporate bonds and even stocks, Tipp says. Scared off by Ireland's troubles, investors have fled to treasuries. "You've got a demand for treasuries that's pushing yields down below where they otherwise would be without that," Schreft says. Yields would have risen regardless of whether or not the Fed initiated another round of easing, she argues.

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The economy may be improving faster than expected. "There's too much focus being placed on QE2—its success or lack thereof—on the movement in things like the dollar and yields, and I think some of it is just basic economic fundamentals," says Liz Ann Sonders, chief investment strategist at Charles Schwab. Sonders argues that the economic situation is improving, especially from where it was in August. When the economy picks up steam, she says yields are expected to rise. Sonders cites a number of economic indicators, including consumer spending, that show the economy is recovering. Real—or inflation-adjusted—consumer spending is now officially in "expansion" mode—meaning it has surpassed the 2007 peak. It's important to remember that the Fed has said that it will "regularly review" and "adjust the program as needed." Sonders says there's actually a small chance that the Fed could look at the pace of the economic recovery and decide to cut back on some of its asset purchases if it believes the economy doesn't need it anymore. "I think the message of why they would be paring it back, i.e. an economy that is moving into expansion mode ... I think would be a pretty positive message for the market," she says.