History of Monetary Policy

In the 1940s as World War 2 was ending and the world agreed to make the dollar the new reserve currency, the Federal Reserve was engaged in a battle to keep interest rates low. To accomplish their goal, the Fed fixed short-term and long-term rates, then engaged in massive open-market operations, or what we refer to today as Quantitative Easing.

To keep rates pegged, the Fed purchased large amounts of Treasury Bills when short-term rates rose and sold Treasury Notes and Bonds when rates fell. During the 1940s it was well understood that when the Fed purchased securities it was attempting to lower rates and when it was selling securities it was attempting to raise rates.

Today, investors believe the Fed’s actions have the exact opposite reaction. While investors today can be right in the short term, by failing to study the history of how the Fed’s policies work, they will eventually find themselves on the wrong side of the market.

By fixing short- and long-term rates, the Fed was hoping to create a positively sloped yield curve. When the yield curve is positively sloped, short-term yields are lower than long-term yields. While it may seem odd, at the time there was not much demand for short-term Treasury Bills so the Fed was forced to intervene to prevent short-term rates from rising and long-term rates from falling.

There was such a lack of demand for Treasury Bills in the early 1940s that the Fed was forced to purchase any amount the dealers could not sell. As a result, the Fed’s balance sheet of Treasury Bills ballooned, and rates held their peg.

When the supply of Treasury Bills exceeded the demand for Treasury Bills, the price of T-Bills fell and yields rose. To prevent yields from rising, the Fed was forced to buy all the excess supply. While it is unknown how high rates might have risen had the Fed not intervened, it is clear that when the Fed purchases securities it is trying to suppress or lower rates.

Today, we have the opposite problem. There is a surplus of cash in the financial system and an insufficient amount of Treasury Bills to back all the cash. When the demand for Treasury Bills is more than the supply of Treasury Bills, prices must rise and yields must fall.

In search of yield, investors in the 1940s went out the curve since the Fed was pegging both short- and long-term yields. Due to the increase in demand for long-term Treasury Bonds, investors were able to capitalize on the increase in bond prices in addition to the yield as rates fell below the Fed’s stated peg.

Today, the Fed is not fixing long-term yields but they are trying to drive long-term yields lower by purchasing large amounts of Treasury Notes and Bonds. Investors today are faced with the same dilemma investors were faced during the 1940s.

Courtesy of the Fed’s overnight reverse repurchase agreement program, short-term rates are essentially fixed at 0.05%. Due to the excess demand for Treasury Bills, as evident by the massive amount of cash sloshing around the commercial banking system, short-term yields would be negative had the Fed not intervened.

Even though the common belief today among investors is that long-term yields must rise, investors face no alternative. To earn a yield on their savings, investors must go out the yield curve. While they may not want to, money managers and commercial banks will be forced to.

As long as the Fed continues to engage in Quantitative Easing and fix short-term rates, long-term Treasury yields must fall just as they did in the 1940s. For bond investors, it is inevitable the Fed will eventually flush out all of the short sellers and drive long-term bond prices significantly higher.

History has already shown us how the Fed’s policies work and despite investor’s bets against the Fed, the Fed will prevail. Owning bonds is betting on the Fed, which has shown repeatedly throughout history that they can and do win in the end. Except for this time, the Fed will orchestrate a massive deflationary crash that will send bond prices to new all-time highs.