How Quantitative Easing Affects the Yield Curve

Quantitative easing (QE)—a central bank’s purchase of longer-dated bonds and other assets—directly reshapes the yield curve. By buying large quantities of longer-term debt, central banks reduce the supply available to private investors, lower yields on those bonds, and compress the term premium that investors demand for extending maturity. The result is a flatter yield curve, lower borrowing costs for longer-dated projects, and a shift in the incentive to borrow and lend across the economy.

The Yield Curve and Term Premium

To understand how QE affects the yield curve, start with the term premium. The yield curve shows the relationship between bond maturity and yield. If short-term rates are held near zero by the central bank, and longer-term bonds yield 2%, that 2 percentage point spread includes two components:

1. Expected average short rates over the bond’s life. If markets expect the central bank to keep rates near zero for two years and then raise them to 1%, the average expected short rate is lower than 2%.
2. Term premium. Investors demand extra yield to hold longer bonds because they are exposed to interest-rate risk: if rates rise before maturity, the bond’s value falls. Longer bonds have more interest-rate risk, so investors want more compensation.

Before QE, a typical term premium on a 10-year bond was 1.5 to 2.5 percentage points. An investor holding a 10-year bond wanted that extra yield to justify giving up the ability to reinvest at possibly higher rates later.

How QE Compresses the Term Premium

When a central bank announces large-scale asset purchases (QE), it removes a huge amount of longer-dated bonds from the private market. The Federal Reserve, for example, might buy $600 billion in Treasury bonds maturing in 5 to 30 years. This immediately shrinks the supply of bonds available to private investors.

With supply down and demand from the private sector unchanged, prices rise and yields fall—the mechanical effect. But there is a deeper channel: scarcity and demand substitution.

As the Fed removes longer-dated Treasuries, investors cannot simply stop investing. They must reallocate to other bonds or assets. They:

• Buy longer-dated bonds from other issuers (corporate, mortgage-backed, etc.), pushing down those yields too.
• Reach for riskier or longer-maturity assets to find yield, compressing credit spreads and extending duration.
• Reduce their demand for the term-premium premium itself, because central bank action signals confidence that rates will not spike unexpectedly.

The last point is critical: QE is often deployed when recession risk is high or monetary policy is deadlocked. By signaling that the central bank will hold rates low and purchase bonds aggressively, it reduces tail risk. Investors feel safer taking on maturity risk without demanding as much compensation.

The result is that the term premium collapses—sometimes to near zero or even slightly negative (meaning investors will hold long bonds even at lower yields than short-term bonds).

The Flattening of the Yield Curve

With the term premium compressed, the gap between short-term and long-term yields shrinks. The yield curve flattens.

Consider a stylized example:

• Pre-QE: Fed funds rate 0.25%, 10-year Treasury yield 2.0% (term premium ~1.75%, expected average short rate ~0.25%). The curve slopes up steeply.
• Post-QE: Fed funds rate still 0.25%, but the 10-year Treasury yield falls to 1.0% (term premium compressed to ~0.75%, expected short rate unchanged). The curve is much flatter.

This flattening can be dramatic. During the Federal Reserve’s QE programs after 2008, the 10-year yield fell from over 3% to below 2%, while short rates remained near zero. In 2020–2021, after the COVID shock, QE drove the 10-year below 1%, despite economic recovery expectations.

In extreme cases, the curve can invert: long-term yields fall below short-term yields. This happened in 2022 as the Federal Reserve hiked short-term rates while markets doubted the Fed would sustain high rates, so long-term bond prices still rose.

The Credit Spread Dynamic

A subtlety: while QE compresses the term premium (the premium for maturity risk), it often widens credit spreads (the premium for default risk). This seems contradictory, but the mechanism is clear.

When a central bank buys Treasury bonds, it directly affects the risk-free yield curve. But investors do not hold only Treasuries. They also hold corporate bonds, mortgage-backed securities, and other credit instruments. As Treasury yields fall, investors demand more extra yield (a wider spread) to compensate for credit risk, because they are holding that credit risk in a lower-rate environment where default probabilities may be rising.

During a recession (the typical QE scenario), credit spreads widen because default risk rises, even as Treasuries rally. The central bank is essentially saying, “I will keep the risk-free rate low to support credit markets,” but that does not eliminate credit risk itself.

Real-World QE Episodes

Federal Reserve (2008–2014, 2020–2021)

The Fed purchased over $4 trillion in longer-dated Treasuries and agency mortgage-backed securities. The 10-year Treasury yield fell from over 3% to below 1% during QE1–QE3 (2008–2012). Short-term rates stayed at zero. The yield curve flattened and stayed flat throughout the recovery.

European Central Bank (2014–2018)

The ECB announced negative deposit rates and large-scale asset purchases. The 10-year German Bund yield (a key benchmark for eurozone borrowing) fell below 0.5% and even turned negative at times. European governments and corporations could borrow at very low rates.

Bank of Japan (1999–present)

Japan’s QE programs lasted decades. The Bank of Japan eventually capped the 10-year yield around 0%—not by directive, but by committing to buy unlimited quantities at that yield. The yield curve remained flat or inverted for years.

Bank of England (2009–2012)

The Bank of England purchased £375 billion in gilts. The 10-year gilt yield fell from 3.5% to below 1.5%. Like other major central banks, the BoE’s QE compressed the term premium and flattened the curve.

The Portfolio Balance Channel and Beyond

The mechanism above—scarcity reduces term premium—is the most direct. But central banks also work through portfolio balance: by removing longer bonds, the central bank forces investors to rebalance into equities, real assets, and other riskier instruments. This can inflate asset prices and stimulate the real economy.

Additionally, QE operates through expectations: when a central bank commits to holding rates low and buying bonds, inflation and growth expectations may rise (for better or worse). If investors expect higher growth and inflation, they may demand more yield for longer bonds, pushing long-term yields up. This partially offsets the mechanical yield-compression effect.

The outcome—whether yields fall or rise—depends on which effect dominates.

Exit and the Yield Curve Steepening

When central banks end QE or taper purchases, the reverse dynamic can play out. As supply of longer bonds increases again (the central bank stops buying), and investors reduce purchases, yields on longer bonds can rise. Simultaneously, as economic recovery accelerates and the central bank raises short-term rates, the curve may steepen.

After the Fed ended QE3 in 2014 and later hiked short-term rates (2015–2018), the 10-year yield rose and the curve steepened. The term premium normalized as investors again demanded more yield for duration risk.

In 2022, as the Fed raised short-term rates aggressively and ended its balance-sheet expansion, the 10-year initially fell (because growth and inflation expectations fell), but as recession risks eased, the curve steepened. The term premium widened back to more normal levels (though still below pre-2008 averages).

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