Evidence on The Portfolio Balance Channel of Quantitative Easing by Daniel L. Thornton

Interesting paper about the useless effect of QE. I´m not pretty sure about the validity of this argument but anyway the paper explains the portfolio balance channel theory.

PAPER 

"Most analysts (e.g., Bernanke, 2010; Gagnon et al. 2011) suggest that QE works by reducing the term premium in longer-term yields through the portfolio balance channel. The portfolio balance channel is based on the Markowitz portfolio theory which hypothesizes that an investor will hold a portfolio that maximizes the investor’s utility, which is a function of the expected return on each item in the portfolio and the expected risk. For each possible investment the investor has a probability density function. The proportion of the investor’s total wealth invested in each asset (each asset’s portfolio weight) is determined by maximizing the investor’s utility over all possible assets. Utility is assumed to be a function of risk and return, where the risk proxy is the standard deviation of the asset’s return. If the market is populated by risk-averse investors, the equilibrium structure of rates occurs when the risk-adjusted rates of returns on all assets are equal. Differences in the returns on any two assets depend solely on investors’assessment of the risk of holding these assets; the riskier the asset, the higher the rate of return.

The equilibrium structure of rates is independent of the supplies of the various assets in the market. Consequently, it would be useless to attempt to manipulate the yield on a particular asset by reducing its supply.

This means that QE can reduce longer-term yields if and only if the market for longer-term debt is segmented from the rest of the market: A subset of market participants must have a preference for holding long-term Treasuries. Gagnon et al. (2011) suggest that QE reduces long-term yields because the Fed’s LSAPs “have removed a considerable amount of assets with high duration from the markets. With less duration risk to hold in the aggregate, the market should require a lower premium to hold that risk.” 1 They suggest that “This effect may arise because those investors most willing to bear the risk are the ones left holding it. Or, even if investors do not differ greatly in their attitudes toward duration risk, they may require lower compensation for holding duration risk when they have smaller amounts of it in their portfolios.”  

Hence, according to Gagnon et al. (2011), long-term yields will decline because (1) there is a change in the distribution—the riskiest assets will be held by the investors who are the least risk averse or (2) investors will require a smaller term premium because their portfolios are less risky as a consequence of the Fed’s purchase of longer-dated debt."