Forget QE3 – China and Japan Hold the Key to US Interest Rates

While it is not exactly clear what Ben Bernanke wants to achieve by purchasing financial assets, I think he wants to lower long-term interest rates. If this is the objective then we must consider what happens to the money the Fed releases when purchasing assets.

Suppose the Fed buys a mortgage security using cash. The seller can take that money and decide to buy another long term asset or they can decide to hold cash. If the seller elects to hold cash then the net effect of the Fed’s purchase is neutral – the same number of mortgages and cash holdings remain, the only difference is that the ownership has changed. Is this likely? Absolutely, since one feature of the Fed’s asset program is that purchases are ‘sterilised’ through the issuance of T-bills and deposits with the Fed. Cash out, cash in…QE3 would seem to be neutral. To systematically influence asset prices, there must be some leakage/injection that causes the net excess demand for assets to change at the microeconomic level. Like every Keynesian ‘stimulus’ initiative, QE3 fails to deliver on basic microeconomic reasoning.

So how can long term interest rates fall? A recent US Government report highlighted the fact that China resumed their purchases of long-term US Treasuries in July after electing to build up cash holdings for the previous three months. Unlike Fed asset purchases, China’s asset purchases are not sterilised so that the seller of the US Treasury Bond has to find a place to invest their cash – cash out, remains out. It may take some time but eventually new financial assets have to be created which, at the microeconomic level, means new investment projects. The interesting feature of China and Japan’s demand for US assets is that their trade surpluses fund their purchases – this leakage reversal is the micro reason for lower interest rates.

Judging by the behaviour of the US Treasury market, the renewed demand from Asia seems to be capping any upward pressure on interest rates. During August, for instance, a sharp sell-off in Treasuries attracted buyers from Asia. The same dynamic appears to have surfaced in September.

Rather than try to work some convoluted alchemy with QE3, Ben Bernanke should pray that cheap labor in China continues to deliver the trade surpluses which find their way into US Treasuries!