In a theme which has become familiar Friday saw a leading indicator for the United States economy point towards a further slowdown. The ECRI leading indicator growth rate in fact did something of a reversal as in the previous week it had fallen from double digit declines to -9.8. This week it not only fell back into double- digit declines at -10.0, but also the previous week was revised from -9.8 to -10.2. Now leading indicators are not entirely reliable particularly in such times as this but they cannot be completely ignored. After a generally weak week the US Dow Jones Average fell some 57 points to 10213,which is the lowest it has been for a month. Over the weekend the very uncertain result of the Australian election began to emerge but in fact in a situation which mirrored the recent similar UK experience financial markets have taken it rather calmly.
There were over the weekend several scare stories in the UK media about rising commodity prices and the potential for “agflation”. This included one by the Sunday Times which stated that the price of a christmas dinner would be much higher this year. Quite how they are so sure of this is not entirely clear as there are four months to go and much can happen. In the event on Friday the Commodity Research Bureau spot index fell back by 1.82 to 450.73 with all components falling. One of the rules of thumb about this sort of thing goes as follows, it takes journalists quite some time to gather the courage to write on a topic, however many moves are transient so they often gather the courage to write about it just as the trend either reverses or reaches a near-term top.
Government Bond Price rallies have they been caused by Quantitative Easing?
This is an issue that in some ways looks like it has an easy answer but in fact turns out, in my view, to be not quite so simple. If we look at the recent experience of the United States we saw the emergence of a new policy called QE- lite from its central bank the Federal Reserve back on August 10th. On this date it announced that the amount of securities it holds will be kept stable and that as its holdings of mortgage-backed securities mature it will use the money it receives to invest in US Treasury Bonds (government debt). This will lead to approximately US $20 billion per month being invested in US Treasury Bonds although the stream is somewhat irregular.
Since this date we have seen quite a rally in US Treasury Bond prices and a corresponding fall in yields. For example the yields have fallen as follows, the 2 year from 0.54% to 0.49%, the 10 year from 2.82% to 2.6% and the 30 year from 4.01% to 3.64% and all in less than a fortnight. Whilst there have been other influences such as a slowing US economy much of the fall took place quite quickly after the announcement.So there is plainly quite a strong link and similar moves took place in the UK back in March 2009 when the Bank of England began buying UK government debt. So there is a clear link between a flow of government bond purchases by a type of QE and a fall in government bond yields.
What happens as time goes by? The UK experience.
Here we move onto a different concept. Having seen that it is fairly clear that central bank purchases of government debt usually reduce government bond yields this begs the question of what happens next? If we take the UK as an example of this the last purchases of UK government debt took place in February of this year and the amounts purchased had been slowing towards the end. So going forward as there have been no plans to reverse this policy we have the Bank of England holding some £198 billion of UK government debt which was just over a year’s issuance of such securities at the time and we are facing a future where we expect this to remain so. At first this idea of a “stock” concept seems to give an easy result as UK 10 year gilt yields are currently at 2.98% and the 30 year yield is at 4.02% as these are low levels one might also declare victory for the stock concept. The fact that these are in effect signalling negative real yields if the recent UK inflation performance continues may signal a further victory for the stock concept as UK inflation as measured by CPI has been above 3% for all of 2010 so far and as measured by RPI it has been over 5% and is now 4.8%.
However much more caution is required as if one looks back to the spring of this year when we were subject to both flow and stock effects on UK gilt yields we saw a different pattern. For example if we take the 10 year gilt yield at the end of February it was 4.03% and at the end of March it was 3.95%. These were times when a “flow” effect may still be evident and the stock effect is the same as now. Yet yields were at the 10 year maturity a point or more higher than now.
The core Euro zone Experience
By this I mean the countries which are part of the euro zone which have not been subject to the European Central Bank’s Securities Markets Programme which purchased the government debt of some of the weaker euro zone nations. For example there has been no QE in Germany. Yet German government bond yields are hitting lows and in some cases all time lows. Her 10 year bund yields 2.27% and her 30 year’s yield has dipped below 3% to 2.92%. You are perhaps thinking that this is because the German economic locomotive has been picking up steam recently. If you put to one side the fact that picking up steam economically usually raises and not reduces government bond yields then French 10 year government bond yields have dropped significantly too and are now 2.6%.
If one looks back a year and compares the 10 year government bond yields of the UK France and Germany with their yields then you get the following, UK -0.63%, France -0.93% and Germany-0.99%. Now one needs to treat such comparisons with care as a year ago the UK presumably had depressed bond yields as QE was in full flow but countries with no QE have seen very large falls in their government bond yields too.
The peripheral euro zone experience
Here we see an interesting effect. The peripheral euro zone countries have seen rather a mixed effect from the ECB’s Securities Market Programme which purchased some 65 billion Euros of government and private debt in an effort to “stabilise” markets which were in “disequilibrium”. Now we do not know the national breakdown of the purchases but there have been widely different experiences. The best is Portugal where her 10 year yield has dropped by 1.75% but the Irish fall of 0.58% over the period is little different to what happened in many countries with no such programme of purchases over the period for example France’s fell by 0.54%.I feel that as well one has to take into account the official and political dithering which had taken place up to the introduction of the Securities Market Programme which leads me to conclude that almost any sensible policy might have reduced government bond yields in some of these countries. In short we were seeing what was not far short of panic.
Greece seems a simpler example as her 10 year government bond yield was over 13% and is now just below 11%. However her government bond market has shown signs of freezing up and I suspect the real effect here was finding a buyer of any size at all.
Conclusion and Comment
Looking at the evidence shows that the effects of QE on government bond yields is not as clear-cut as it may at first appear. Yes there is an initial flow or shock effect which is favourable. However we have been through periods where the stock effect in countries like the UK which have central banks holding large quantities of their own government debt can be outweighed by other factors as they were in the spring of this year.Other countries such as Ireland appear to have had small benefits even from the flow effect.
As this yield effect is one of the ways that QE is supposed to affect the wider economy by reducing the general level of longer-term interest rates such as corporate borrowing and fixed-rate mortgages then one can see that there is probably an effect but not as much as may have been assumed. If we take this one step further to try to measure the economic effect of this as in how people respond to this then things become more troubling. Whilst there is evidence of increased corporate borrowing in the UK and US to take advantage of this we are not seeing clear economic effects from this in the US. As we have been through a period of quantity problems where companies have been unable to borrow almost regardless of price it makes me wonder if some of the borrowing is to this end i.e if it is cheap (remember IBM borrowing at 1% per annum for 3 years) why not do it even if you do not actually need it. If this is so many normal economic relationships will break down. This is a recurrent theme of post credit crunch life.
Having written before that I have questions about the economic impact of the falls in short-term interest rates I now find I have questions about the economic impact of falls in longer-term interest rates too. As these factors have strong weightings in official economic models I wonder yet again if a lot of official policy is likely to be ineffective.
The effect of the fall in government bond yields on the banks.
One effect of this trend however it has been caused will be welcomed by those who feel that the world’s banks have had too easy a ride since the beginning of the credit crunch. After all they were a big contributor to it. Their reward for this has been to be giving as much cash as they want at very low levels of interest from central banks which they have been able to invest in higher yielding assets such as government bonds and thus being given easy profits. Well with the falls in government bond yields this is no longer quite as profitable. Those who are tired of the cycle where we are told investment bankers deserve high salaries because their work is complicated and involves high levels of skill will welcome the end of a trade which is in fact easy and simple.
So there is a downward effect on investment banking profits from this although they will have benefitted from an initial effect of rising prices on their current holdings. So we can expect a phase of bonuses all round perhaps over the next few months.Should this be followed by losses as life becomes more difficult I somewhat doubt this bonuses will be repaid. Again we see a familiar theme.