What You Need To Know About QE & Low Rates 1

We now know that QE does not work through the bank Reserves channel. But what about the interest rate channel?
Modern central banking does, after all, revolve around trying to control interest rates in the economy in a bid to stimulate or temper growth based on levels of inflation.
Does QE’s dampening effect on interest rates help stimulate economic growth?
Before we can discuss the question, an explanation of how QE lowers interest rates across the economy is in order.
It starts with Central Banks buying up large quantities of sovereign debt from banks. Their demand in the market for these instruments pushes up their price, and consequently lowers their yield.
Lower yields on government debt securities in turn lower interest rates in the broader economy as the risk free rate component on debt is now lower.
This lowering of rates doesn’t happen magically however, fixed income investors bid up corporate bonds in the primary and secondary markets, driving up their prices and lowering their yields. Investors do this because they want to earn higher yields than what is on offer in the now QE suppressed sovereign debt market.
This behavior is termed yield seeking, and is a migration that happens all along the risk spectrum. It begins with holders of government debt who start allocating more capital to debt with marginally higher yields, say highly rated corporate debt.
Since the market perceives government debt as the safest fixed income instruments, the stuff that is next safest would be AAA corporate debt, and the investor has now moved down the risk spectrum.
Of course as this migration happens, AAA corporate debt yields fall, forcing the investors who were previously happy to camp in this part of the spectrum to move down the risk spectrum into the next safest slices of corporate debt.
This process continues all the way down to the riskiest parts of the credit spectrum, which is commonly termed “high yield”, or more colloquially, “junk bonds”.
This process is how QE acts through the interest rate channel, lowering borrowing costs for companies and rates of return for investors.
It is important to note that Central Banks do this at the cost of driving investors into riskier and riskier asset classes, all in the name of trying to boost economic growth.
But does it?
To be continued…
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