What If Central Banks Are Not The Main Reason Rates Are Low?

There seems to be a consensus among investors and asset managers. The expansion of central bank balance sheets through the purchase of sovereign bonds pushed and is keeping bond yields low. Some observers suggest that the central banks' QE has paved the way for the rise of populism by taking by neutralizing the ability of capital to go strike. If the bond vigilantes wanted to express their disapproval for a set of policies by selling or boycotting a country's bond market, the impact would be diluted by the central bank buying.  

This seems intuitively obvious, and yet it strikes us as likely wrong, leading to poorer investment choices and weaker policy decisions. Surely, Italy's recent experience offers a powerful refutation that interest rates cannot rise sharply while the ECB is buying bonds. The 10-year BTP yield jump from about 1.70% on May 4, two months after the national election, to a high on May 29 near 3.44%. Italy's two-year yield surged from minus 33 bp to284 bp on May 30. The ECB bought roughly the same amount of Italian bonds ( a little more than 3.5 bln euro) in May as they have bought monthly since the start of the year.  

Private sector investors reacted strongly to signs that the risk that Italy would leave the monetary union were increasing based on the declaratory policy of some members of the new government. Subsequently, and perhaps beginning at the recent G7 summit and through the new finance minister's interview in the local press, perceptions have changed. Today, Italy sold 5.63 bln euros of bonds (three to 30-year maturities), and the demand was robust. Of the four different tenors, only one was under-subscribed.  

This seems to suggest that central bank buying is the not shackle on bond vigilantes.  In turn, this encourages one to think through it again.Why are interest rates low? Many economists (and policymakers) doubt that the asset purchases (QE) have been particularly effective. Maybe the Fed's first round, when interest rates were still high, it was more effective. The following rounds are thought to have less effect. Indeed ahead of the QE announcement yields would fall, but during the Fed's QE interest rates often rose. By the time the ECB launched a proper QE ( as opposed to Trichet's SMP effort), yields had already fallen.  

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Read more by Marc on his site Marc to Market.

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