Here's Why QE2 Had A Different Response In Currency And Bond Markets

QE2, News, and Differential Impacts in Asset Markets

Typically, economists assume that news, defined as information that induces revisions to expectations of the future value of relevant variables, should affect asset prices simultaneously, and in a consistent manner. That’s why today’s announcement of QE2 has somewhat surprising effects, if one is to believe that QE2 had already been priced in [0].

QE2’s Impact on the Exchange Rate

First, consider the impact on the USD/EUR exchange rate.

Chart EuroUS


Note the fairly large impact on the exchange rate; the dollar depreciated by about 0.43% (log terms) by about 6pm Eastern time. If QE2 had been fully priced in, then (in a risk-neutral investor world) there should have been no impact on the exchange rate. It’s hard to argue that the amount of quantitative easing — $600 billion worth of purchases of long term treasuries — announced was much larger in magnitude than what the market expected; hence the puzzle. (Note, however, the USD/JPY did not move appreciably, while USD/GBP appreciated; but USD/EUR is the dominant currency pair so I’m putting greater weight on this rate.)To see this, let the exchange rate equal current fundamentals and the interest differential and uncovered interest parity holds:

st = Mt + λ(Etst+1-st)

st = [1/(1+λ)]Mt + [λ/(1+λ)]Etst+1

Where s is the log exchange rate, expressed in terms of home currency required to buy a unit of foreign currency; and Et(.) is the mathematical expectations operator, conditioned on the information set available at time t.

Then note that:

st+1-st = (st+1-Etst+1) + {Etst+1-st}

Substituting in the expression for the exchange rate, one obtains:

st+1-st =[1/(1+λ)](Mt+1-EtMt+1) + [1/(1+λ)](Et+1st+2-Etst+2) + {Etst+1-st}

Note that “news” shows up in two places: first, as “surprises” in the fundamentals, namely realisations of the fundamentals that differ from what was expected; second, as information that forces revisions in the expectation of the exchange rate in period t+2, possibly due to expected changes in M in periods t+3 and t+4 and so forth. On 11/3, no actual purchases of long term Treasurys were implemented, so the first term drops out. However, the second term possibly remains — but news accounts suggest that there was no surprises in the magnitude of the planned purchases. [Note: there is a tension between using something that looks like a flex-price monetary model with UIP for motivation, and modelling quantitative easing — but I think it’s not an essential problem.]

My conclusion is that QE2 was mostly, but not entirely, priced into exchange rates. This is buttressed by a time series plot encompassing the period when QE2 was becoming increasingly discussed as a reality.

Chart fedbroad

Figure 2: Log nominal value of USD, Bank of England index (blue), and Fed broad index (red), rescaled to September 1, 2010 = 0. Sources: Bank of England and Federal Reserve Board via FREDII.

A Different Response in the Bond Market

However, the puzzle reappears to the extent that the bond market seemed to take the announcement in stride, and indeed CR argued that the monthly purchases were in line with expectations (if not under-expectations, see here [1]). 30 year yields actually rose; this was attributed to the fact that the purchases were expected to be in the 2.5 to 10 year maturities.

To those who work with models wherein asset markets are linked together by way of arbitrage, this is odd. One market responds and the other does not. Contrast this with the March 18, 2009 announcement of purchases of long term bonds.

chart bond yields

I can think of several reasons for this divergent outcome. One is that different markets have different market participants that have different expectations (not always — but in this episode). This view is anathema to adherents of many standard asset pricing models, as it implies big arbitrage profits are possible (and not exploited). I’m amenable to the idea that there are numerous institutional impediments to arbitrage which might allow for such deviations to persist. Alternatively, nominal interest rates might be incorporating offsetting liquidity and inflation expectations effects, so that the observed impact Treasury yields is essentially zero. Of course, why this occurred in this case, and not in March 2009, needs to be explained.

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.