Yesterday was yet another day of equity market volatility and it started with European equity markets falling with the UK FTSE 100 index going below 5000 several times during the day, but this was followed by a late afternoon rally on Wall Street with the Dow Jones rallying and ending up 123 points higher on the day for yet another triple digit day (22 out of the last 28 now I think). So there are still clear signs of uncertainty and fear surrounding them. However today I wish to look at bond markets and the impact of quantitative easing (QE) on them as there was news on this subject from the European Central Bank and I have been doing some analysis of the Bank of England’s experiment in this area.
The UK experiment with Quantitative Easing
This was formally announced on the 3rd March 2009 where HM Treasury gave the Monetary Policy Committee (MPC) formal permission to make £150 billion of asset purchases of which £50 billion could be private-sector assets. The operation of the plan was down to the MPC and it decided in its March 2009 meeting that it would start by purchasing some £75 billion. Now it was expected at the time that these purchases would mostly be of UK government bonds (which are called gilts) but it was not fully realised that 99% of them would turn out to be gilts. The MPC choose to extend the programme to a size of £125 billion in its May 2009 meeting, then to £175 billion in its August 2009 meeting, and finally (so far) to £200 billion in its meeting in November 2009.
As I wish to look at today the impact of these purchases on the UK gilt market I will further specify what happened. The first gilt purchases were made on the 11th March 2009 and the last were made in the week of the 28 th January 2010. Purchases were made in the 5 to 25 year maturity range.
What was the impact of this?
There have been various estimates of this in particular one by the OECD which estimated that the programme had reduced gilt yields by between 0.5% and 0.75%. However I wish to look at some specific yield figures over a period. I have chosen the 7th of the month to compare yields because those were the latest figures I had last night when I compared the numbers. If we start in October 2008 and look at monthly ten-year gilt yields (from the FTSE gilts indices) until March 2009 we get 4.31%,4.36%,3.85%,3.60%,3.92% and 3.11%, if we do the same for fifteen year gilt yields we get 4.44%,4.66%,4.16%,3.94%,4.33%, and 3.60%.
Therefore it is quite plain that the announcement of QE let to a quite sharp fall in gilt yields across the spectrum with the two maturities yields falling by 0.81% and 0.73% on a month earlier. This was supposed to bring all sorts of benefits to the UK economy as not only were we to benefit as a country from lower gilt yields as debt repayment costs were lower but also there were to be benefits for the private sector with companies for example being able to make cheaper long-term borrowings and individuals being able to access cheaper long-term mortgages. By such impacts the policy was supposed to give a boost to the economy.
As 2009 progressed and we moved into 2010 the yield impact began to wear off. For example ten-year gilt yields rose to more like an average of 3.7% throughout the rest of 2009 and to over 4% in early 2010. The pattern for fifteen -year gilt yields was similar.
The implications of today’s gilt yields
Having taken you carefully through the impact of QE on UK gilt yields. I now wish to tell you what they were as of last nights close. Ten-year gilt yields were 3.44% and fifteen year gilt yields were 3.99%. In case the implications are unclear let me spell it out they are not only below their average during the period during which QE took place, they are in danger of approaching the best period for it. This is a surprising result and show what markets can do and it has considerable implications.
If you remember the beneficial implications of QE I wrote about above well they must be true right now must they not? The UK is in fact getting a considerable boost to its economy from this at this time. Just to repeat my message this boost is as strong as we received from QE. If I was on the MPC I would be considering the implications of this in the meeting today as I feel there is a danger of the economy which is already suffering from high inflation getting too much of a boost and creating yet more inflation. I have written before that I would vote for rates to be nudged up to say 1.5% in response to this and this news only confirms this view.
Why has this happened?
This is a side effect of the sovereign debt crisis and the fear and uncertainty that currently pervades markets. As investors and funds flee what they consider to be risky areas they move to what they consider to be more secure ones. The peripheral countries in the euro zone have suffered from this and indeed for example Greek ten-year bond yields are still around 8.3% in spite of all the measures the euro zone has introduced to support them including getting its central bank to buy them. The flip side of this is that investors look for somewhere that they feel is safe and an obvious example of this trend is German government bonds or bunds. You will not be surprised to read therefore that German ten-year bund yields touched 2.5% yesterday which is its lowest for many years and another example is Japanese ten-year bond yields which dropped to 1.2% with front month bond futures reaching an all-time high of 141.19. Unless fear and uncertainty were around nobody would be buying either of these instrument s at such levels.
We are beneficiaries of the same trend and our yields have fallen too which is rather expansionary. If you look at our domestic economy they are in no way justified but we are being swamped by international trends. As to the expansionary element please remember this when you read elsewhere that the sovereign debt crisis is everywhere contractionary.
The impact of the sovereign debt crisis on the UK is somewhat surprising. Many (including me) have wondered if we would be caught up in the mayhem when in fact we have benefitted from it. However the fall in our gilt yields only confirms me in my view that we need to raise our base rates.
There has been a theoretical debate as to whether the impact of QE depending on it being a flow (how much you bought each month) or a stock (how much you bought in total). Those that have seen this might wonder if my numbers are an argument for the stock argument. However this move is quite recent for example we spent nearly 3 months after the end of QE with ten-year gilt yields above 4% which I think negates this argument.
Other Asset Purchases by the Bank of England
Regular readers will be aware that I have written many times that I feel that the Bank of England should have bought more private-sector debt with its QE programme as I feel that this would have been more of a benefit for the economy than buying gilts. For example the Federal Reserve has had some success with this in the United States. I wrote recently that in spite of looking like the MPC had never really been supporters of this they have been buying some more private sector debt purchasing some £88 million in the last week of May. On Tuesday they purchased another £106.77 million according to their website. So a small start considering they have the right to purchase up to £50 billion but at least they are doing something, although as I have written above one may question if now is the right time.
Fear and Uncertainty
One intriguing issue in the Bank of England buying corporate bonds on Tuesday is that according to the Financial Times it was offered a lot of them some £507.3 million to be precise. It would appear that these investors want cash rather than debt instruments and so they offered to the Bank the highest amount of bonds in an auction since this programme began. It is a sign of the times that they were so willing to sell instruments with a ready buyer (each Tuesday) in return for cash and perhaps we are seeing another sign of a liquidity shortage.
The European Central Bank and its Securities Market Purchases
This programme does not appear to be going very well. If you look at the yields of the government bonds it is buying they are showing no great signs of falling (apart from an initial impact on Greece) and in many cases they are going back up. If we look at ten-year government bond yields we see the problem with Greece 8.29%, Portugal 5.41%, Ireland 5.25%, Spain 4.70% and Italy 4.31%.
The problem is added to by the way that Spain and particularly Italy have joined this list. They are much bigger government bond markets than those of the previous three countries and thus we get the implication that if this programme is to work it will have to be much larger than previously expected. The ECB has not published the size of its programme but I think that those in its headquarters at Frankfurt will now realise it is going to have to be on a much larger scale that they originally thought. I personally thought it would have been better to publish a size for the purchases in the same way as the Bank of England did.
In terms of announcements the ECB bought a further 5.5 billion Euros of government bonds last week making a total of 40.5 billion Euros so far. It has given a hint as to what it expected as each week its purchases have got lower. In my view it will have to reverse this trend which is probably mildly embarrassing but unless it does the problem may get worse and not better. The “sterilisation” programme has not been a success either and in my view offering one week instruments which can be used as loan collateral at the ECB is certainly not full sterilisation.
It would appear that the ECB is not as convinced by its one week sterilisation programme as it claims. This morning it has mentioned monthly debt certificates on its news pages which was rather unwise. Firstly it confirms the market view that these are worthy of consideration and secondly in the words of the Hitchikers Guide To The Galaxy it might have been best to use “big friendly words” such as this is a test when it did it!