Changes in the relationship between Equities and Government Bonds pose worrying questions

After the severe falls in worldwide stock markets which took place on Tuesday I was expecting something of a rally yesterday. What surprised me was how weak it turned out to be particularly after the news on the new 3 month Long Term Refinancing Operation from the European Central Bank. On this more later but a take-up of 132 billion Euros was in many respects better than expected. However equity markets struggled to rally as for example the UK FTSE 100 struggled to 50 points up but then closed only 2 points up. After European markets had closed came more bad news for Spain and this contributed to the Dow Jones Industrial Average closing down 96 points followed by the Nikkei index in Japan closing down 191. I often compare the two as these days they are similar price levels and I notice that during this period the Nikkei has relatively underperformed as at 9191 it is some 583  points lower than the Dow’s 9774. During the lifetime of this blog (since last November) they have “crossed over” and the relative change will have been spotted and noted in Tokyo. Also this equity drop is still something of a stealth fall as far as the wider UK media are concerned as there has been little mention of it, I guess Wimbledon tennis and the World Cup may well be factors in this.

Equities and Government Bonds

Something interesting has gone on in the relationship between these two instruments. By government bonds I mean those of the UK US, Japan, Germany and similar countries. I wrote earlier this week that in my view the yield levels for government bonds in these countries were in my view at such a level that they were predicting a double-dip in the respective economies of these countries and in fact were so low that they were in effect forecasting it. Since then in the United States the ten-year Treasury Note has fallen to a yield of 2.93% so the situation has continued and extended. However even after the falls of the last few days equity markets are much more hopeful with the S&P index at 1030. To put this into context when these yields last fell below 3% the S&P was at 857 (thank you to the FT for the numbers). I hope that this makes the point clear, since then either equities are much more optimistic or bonds much less so.

Are they expecting more Quantitative Easing?

This is a thought that has occurred to me looking at the ten-year government bond yields of the countries I have mentioned. If you look at the UK the initial impact of Quantitative Easing (QE) took our such yields to 3.1% initially and now (without it) we are at 3.35%. If one considers that markets are forward-looking then one must therefore conclude that they may well be discounting QE mark 2. The situation in the United States is similar and so we may well expect a QE Type 2 there. As to Japan hers are now 1.09% and so we cannot rule it out there either although with her persistent disinflation the situation is somewhat different.

I notice some forecasters are now pencilling in new versions of QE and are expecting falls in government bond yields from here. I have two main thoughts on this. Such yields present a frightening view for the world economy and whilst I am nervous of a slowdown I still hope we can avoid the worst which in such a scenario would be heading towards Depression levels. Secondly as a taxpayer I have a thought for all the taxpayers reading this, we will be buying our own bonds at what are extraordinary levels in recent experience. To my mind it is likely to make QE mark 2 even more risky and dangerous for the future than the first. I return to a point I have made many times if it is such a wonderful idea why do we not issue all our debt to ourselves and stop bothering to sell it?

TARP Funds

I notice on this subject that US Senators have approved the use of TARP funds for other purposes again, this is really profligate and shows I am afraid to say that if money is voted for a purpose  then our current group of world politicians are in general unable even in these times to show some fiscal discipline. It is a problem of our times with elected politicians effectively still two years into a crisis being fiscally incontinent and does not bode well. If you think about it you end up with the view that on such projects you can only have an overrun because any shortfall will be spent.

In terms of detail a planned 19 billion US dollar bank levy was replaced with left-over TARP funds. Apart from the obvious irony of the use of the money it somewhat goes against the IMF’s review of the United States that feels it needs more fiscal discipline. Quite.

The European Central Bank and the expiry of its 12 month Long Term Refinancing Operation

After yesterday’s news that of the expiring 442 billion Euros from the ECB’ 12 month LTRO some 132 billion had gone into its new 3 month version i posed the question what about the remaining 310 billion Euros? I was asked on here as to the effect of the ECB’s Main Refinancing Operations which have grown to 163 billion Euros. To this I reply whilst this has grown from around 54 billion in January it has only grown by around 11 billion Euros over the last week so some funds may have gone into it from the 12 month LTRO but it is likely to have been a relatively small player.

On this front the ECB has become an enormous player in the money markets. If you add up all its various schemes and operations they come to around 900 billion Euros so I think the debate may go on. We will get another clue this morning as the ECB is operating a 6 day tender and some feel that funds may have gone into it. Much more of this and we may have to call in Sherlock Holmes! More seriously the forensic nature of the investigation shows the level of concern about this issue. There is some fear I think.


Looking at the ECB it has in effect taken over much of the role of interbank markets in the euro zone. We now have two types of bank those who can fund themselves normally and those who cannot and have to rely on the ECB. For those who do not follow this area then let me apologise for the acronyms I have used ( which can be complicated and confusing) and just simply let me say the issue is the scale and nature of its operations. At a time when emergency measures were supposed to be withdrawn it would appear that the ECB is in fact expanding its role. This is not a success.

Spain gets threatened with a downgrade

At the moment Spain is not getting much luck. Apparent good news is rapidly being dashed. For example news that her two biggest banks BBVA and Santander had done well in the euro zone bank stress tests was undone when it was leaked that these tests did not reflect sovereign risk. This leak was received with derision by financial markets and yet again showed how out of touch euro zone officials and ministers are. Then yesterdays good news on the LTRO was followed by Moody’s Ratings agency announcing that it was putting Spain on what it calls negative watch. Its statement referred to some issues I have raised on this blog before.

In the short-term, the government’s accelerated fiscal consolidation combined with the higher borrowing costs currently facing the government, consumers, and businesses will likely depress growth. From a longer-term perspective, it will take several years for the economy to adjust to the fallout from the collapse of the real-estate boom, to reduce the high level of private sector indebtedness to levels more in line with other EU countries, and to find new, internal sources of economic growth.

So it is worried about the impact of the austerity programme on an economy which so far has not fully dealt with the consequences of its housing boom on its property and banking sectors. It also has a view on the optimism ( I am being polite…) of Spain’s official forecasts.

Moody’s own forecasts for Spain’s fiscal deficits are higher than the government’s targets

I notice that in an interview with the FT that Moody’s makes what I feel is a crucial point.

They’re trying to do a lot in a relatively short period of time, after having postponed some of these measures until now


Whilst there are many issues concerning the ratings agencies and Spain as regards the differences between them I feel that Moody’s analysis is quite accurate. On a day when the weaknesses of politicians seems to be popping up more than once Spain’s government does I feel have questions to answer about her dithering and hoping for the best through much of the recent crisis. I wrote on this general subject on the 2nd April when I was comparing Ireland with Greece and discussing if there would be a reward for Ireland being prompt and pro-active, many of these themes apply in reverse to Spain.

As to today Spain has issued some five-year government bonds and on an initial look it has not gone too badly as the yield has only risen from 3.53% at the time of her last issue to 3.66%. As of last night her ten-year government bond yield was 4.7% which if you take out the period of her recent government bond auction has been a reasonably consistent level. However this month involves quite a bit of government bond issuance for Spain so this subject will return.

A More General Theme

This week to my mind has an underlying theme which is occurring more and more and it is expressed best as a question, did the extraordinary measures taken by monetary authorities defeat the credit crunch or merely kick the can down the road? If they merely kicked it down the road then next time around we will be weaker as some many resources have already been used…


9 thoughts on “Changes in the relationship between Equities and Government Bonds pose worrying questions

  1. Hi Shaun,

    The answer to your question is clearly I feel that all the authorities have achieved with their tinkering is to postpone what would have occurred, and to ensure that it will now be much worse when it eventually does occur. They have been desperately attempting to avoid the inevitable economic correction now required after years of a credit binge in Western economies generally.

    Their efforts will all come to naught, except that QE MkII will ensure rampant inflation ultimately if all of the QE is not not fully redeemed in the required original Keynesian manner (which I do not believe will ever be done, just as it has been avoided in all previous examples).

  2. So, the output gap theory is now questioned within the MPC, Paul Fisher says ” The ‘output gap’ appears to be much smaller than the fall in demand alone would have suggested, but there is little evidence of
    widespread destruction of supply capacity. Whatever the balance between demand and supply, it seems that many firms have maintained
    prices, not cut them, in the face of weak demand.” In an interesting twist of logic I see that he argues “When demand growth strengthens, output could be flexibly ratcheted up, reversing the processes seen during the downturn. If so, then it is unlikely that substantial inflationary pressure would be generated as the result of a recovery in demand: there will be plenty of capacity within firms and a ready supply of labour, both of
    which should help to keep costs subdued. But this is clearly a major uncertainty and hence a risk in our projections of future inflation.”

    Now , throw in to the pot a second load of monster QE into an environment of persistent inflation and what would you then have?

    By the way, if there is to be QE mk 2 it should not be used to buy gilts ( at top of market prices as you say) or FTSE bonds and paper. It should, in my view, be used to buy equity in SMEs, regional capital funds and new mutuals and new banks – not the ones which have already been bailed out. Just a view. Ofcourse, BoE has said they wont sanction this approach and that Government would have to do it because they wouldnt stomach the credit risk or chose winners and losers. As if secondary gilt-buying doesnt favour the banks and big business!

  3. Shaun,

    Do you think the ECB ill publish the names of the banks who have made use of the 3 month version of the LTRO?

    Finally, can anyone explain to me the consequences of having a smaller supply capacity, as mentioned in Shireblogger’s comment?

    Thanks very much.

    • Hi Rob
      As to the ECB I would suspect not as releasing the names would put the banks concerned under pressure and would also lead to requests for how much they have borrowed. I suspect that there are banks who without this money would be either very near to or actually in a position where they would be unable to continue their business.

      As to supply capacity this is an attempt by adherents of “output gap” or Phillips curve economics to explain why their philosophy/theory is not working. If we look at the UK if one allows for the falls in GDP we had in 2009 and then put back in expected growth one might say according to output gap theory than GDP is 10% lower than theoretical capacity. This to them means that inflation should fall indeed most of them predicted disinflation (negative inflation and falling prices) based on this theory. Unfortunately for the theory inflation in the UK has rather inconveniently risen. Rather than say the theory is patently obviously not working they have come up with another theoretical construct. This is to say that the credit crunch has reduced the capacity of the UK economy to produce things and so we have a lower supply capacity, let us say by 5%. So now they only have an output gap of 5% rather than 10%.

      So adherents of this still produce an answer that does not fit reality but it has a smaller error.

      If we move onto reality now then there are elements of this which are true. The falls in GDP mean that there will be some spare capacity in our economy. This to my mind makes the inflation we have now more worrying and not less as it is even more extraordinary when you look at what has happened. Also there will have been some productive capacity which has been lost of which the most pronounced would be in the banking sector. But all numbers used are estimates or guesses. So we have a theory which is not predicting reality which many economists are trying to fix by guessing some numbers…..

      • Stop press Shaun : Mr Posen’s speech squares the failure of the output gap theory in the UK by saying that inflationary expectations of ‘private actors’ are on an upward creep due to persistent recent overshoots of the CPI target, but he says “A small slow upwards creep in inflation expectations is not worth panicking over, and certainly is not a reason to tighten policy when the forecast argues against so doing.” I am, presumably, a private actor and monetary boosting and successful government debt issuance reinforced the impact of the overshoots on my expectations, apparently. Hence, I put my prices up.

  4. Could the present Gov live with QE MK2? For all the talk about real independence that is a huge political pill to swallow.

  5. Hi Shaun.. boy did the Euro have a nice day in New York !!
    My make.. the LTRO might be the start of some serious deflation
    In EuroLand.. I give it another month at most before the LIBOR
    forces Trichet to effectively re-instate LTRO. Thoughts ?
    Thanks.. your blog is always a daily read.

    • Hi Mr.K

      I saw the currency moves which included £. Although even we fell against the Euro inspite of a 2 cent rally versus the $. I think some of it was the US figures which continued a poorer trend. The happiest must be the Swiss National Bank which might even get a good nights sleep tonight! As for the ECB there are a lot of questions to which we are only a little the wiser. Rates such as eurolibor and eonia take their time to move. As to another 12 month LTRO well it wouldnt be the first time this year that the ECB has had to about turn recently would it? We still do not know if the unexplained 200 billion Euros out of the 442 billion in fact matches the carry trade of buying Greek and othe peripheral bonds.

      The ral excitement would come if a list of the banks which took up the new 3 month LTRO ever got leaked…

  6. By what mechanism is Depression to be avoided?

    QE: even accepting a view that Bernanke is a bit of a mongrel monetarist when it comes to putting policy in action, if he wanted to maintain the money supply then he shouldn’t have given it to banks, he would have been better off giving the money to the people who owed to the banks.

    With regard to the lack of an “output gap”. Businesses have probably hung on to staff in the (rapidly disappearing) expectation that concerted government action globally would solve the problem. Those expectations are switching.

    Stock market volatility has been apparent for some time. Consistently large drops that have only been clawed back. In my view this behaviour presages a proper crash.

    That stock markets have not in some way figured out how bad things are before now is a head scratcher for me.

    In many cases the major western economies are carrying much larger amounts of private debt compared to GDP than was the case in 1929, with the switch of expectations about the success of public policy a process which is already evident, will accelerate: debt deflation.

    The most likely scenario is that millions of people and thousands of businesses (including many banks) are going to go to the wall. Many more than we have experienced to date.

    The hope is that this is a “price worth paying”, i.e. a short sharp reduction in output will, whilst having long term detrimental consequences for millions of people globally, depress asset prices to a level that part of the private sector that can survive the storm will be reinvigorated.

    People will study the last decade and the coming decade for many generations to come (I hope).

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