A Simple Lesson About Federal Reserve Bond Purchases That Could Save Investors A Fortune

federal reserve

[credit provider=”Wikimedia/Dan Smith” url=”http://commons.wikimedia.org/wiki/File:Federal_Reserve.jpg”]

Remember back in 2011: PIMCO boss Bill Gross famously bet against the US Treasury market on the grounds that as QE2 came to an end, interest rates would surge, because the Fed would no longer be in the market, placing a bid under US government bonds.The story of that bet is well known. Interest rates did not surge in 2011. They plummeted.

By the end of that year, Bill Gross was apologizing to his investors.

So why wasn’t Bill Gross correct? After all, it would seem that Fed purchases of Treasuries should bring prices up and yields down, and that the cessation of purchases should cause prices to fall and yields to rise.

But as economist Scott Sumner wrote in a recent post, it actually works the opposite (usually):

It’s always a mistake to use microeconomic intuition in macro.  People think; “If I buy a few bonds the bond price will rise, so surely the laws of supply and demand tell us that if the Fed buys lots of bonds then bond prices will go up a lot.”

Why is it different at the individual level?  Because when I buy bonds I don’t increase the money supply.  When the Fed buys them the money supply rises. Supply and demand still hold true, but we must think about two markets, bonds and money.  It’s not like a microeconomic S&D problem.  The value of money falls when the supply increases, at least in the long run.  Expectations of a decline in money’s value reduce the expected real value of future interest and principal, which is paid out in nominal dollars.  That’s why more money means lower bond prices, other things equal.

This two paragraphs form a concise rebuttal to one of the biggest myths out there, that Fed purchases have been the main driver behind lower bond prices. Fed purchases aren’t like everyone else’s purchases, since Fed purchases help stoke inflation, and that’s negative for bonds.

A crucial lesson.