Must-know: Monetary stimulus leads to a shift in the yield curve

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What is monetary stimulus?

Monetary stimulus or monetary easing are measures such as the lowering of interest rates, providing quantitative easing or other such methods used to increase the amount of money supply or credit in an economy. In short, it’s a central bank’s attempt to make the economic growth faster.

In the case of the U.S., the Federal Reserve has lowered the federal funds rate and been buying asset-backed secrurities as well as Treasury securities to boost the availability of credit in the economy.

Treasury yield curve - the QE effect

Quantitative easing

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Quantitative easing (or QE) is a form of monetary easing. The central bank purchases government securities or other securities from the market in order to increase the money supply and lower interest rates. QE or the Fed’s mass bond-buying program is considered when short-term interest rates are at or approaching zero. It doesn’t involve printing new banknotes.

The U.S. has resorted to QE three times now

There have been three rounds of QE in the U.S. The first, QE1, was undertaken to provide stimulus to the economy during the credit crisis of Q4 2008. The second round of stimulus, QE2, was initiated in the fourth quarter of 2010 in order to jump-start the sluggish pace of economic recovery in the U.S.

The Fed undertook a third round of QE in September 2012. As you can see in the chart above, the Fed’s QE initiatives have successfully shifted the yield curve downward, lowering the Treasury yields across maturities and making market borrowing costs (benchmarked to Treasuries) lower.

Investment impact

Monetary easing results in lower yields and higher bond prices. It benefits fixed-income exchange-traded funds (or ETFs) such as the iShares Barclays 1-3 Year Treasury Bond Fund (SHY) and the iShares Barclays 20 Year Treasury Bond Fund (TLT). These funds track the performance of short-term and long-term U.S. Treasury securities, respectively.

Stock markets have also benefited from the higher market liquidity brought about by QE. Equity funds such as the SPDR S&P 500 ETF (SPY), the Vanguard Total Stock Market ETF (VTI), and the SPDR Dow Jones Industrial Average ETF (DIA) have gained on the back of improving growth expectations through QE.

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