It was only last Thursday that I discussed and analysed a rise in Euro area bond yields. In fact it turned into such a plummet that it was something of a “flash crash” followed by a sharp rebound. Did it then settle down? Well yes but if we use the ten-year bond of Germany as an example then new yield level was 0.6% which is rather different to the 0.07% we had seen. Last night saw US Treasury Bond prices fell and yields rallied such that right now the ten-year yield is at 2.3% which is a new high for 2015. This has led to a new twist of the cycle as the ten-year bond yield of Germany has risen to 0.7%. So just as the consensus became “down, down” for bond yields we find that apparently “the only way is up”! Intriguing is it not in an era where central banks are operating asset purchases or Quantitative Easing (QE) to push yields lower?! What has happened to the central planners and is the pot boiling over.
The theory of QE
Regular readers will be aware that as events did not develop as it expected the Bank of England changed its view on QE quite a few times. In fact I stopped counting somewhere in the mid-twenties. This of course was a clear sign that things were not going to plan and an additional one was the introduction of a long word called “counterfactual” in an attempt to obscure that fact. However there were clear themes about what was supposed to happen in a QE influenced environment.
This cash injection lowers the cost of borrowing and boosts asset prices to support spending and get inflation back to target.
So we have an implication that bond yields are supposed to fall which is reinforced if we look back to the Bank of England Quarterly Bulletin for the 1st quarter of 2011.
Central bank asset purchases, through this channel, push up the prices of the assets bought and also the prices of other assets.
So they bought UK Gilts totaling some £375 billion pushing up Gilt prices and thereby reducing Gilt of bond yields. That seems clear and they reinforced the theme.
Higher asset prices mean lower yields, and lower borrowing costs for firms and households, which acts to stimulate spending.
Okay and according to the Bank of England Gilt or bond yields did fall.
Summing over the reactions in gilt yields to each of the QE news events gives an overall average fall of just under 100 basis points.
So at that point they felt that they had reduced Gilt yields by 1% and according to the theory below this boosted the UK economy.
Through lower borrowing costs and higher wealth, asset prices then raise demand, which acts to push up the consumer price level.
Indeed the Bank of England went so far as to suggest an impact of all these effects on the economy.
this would suggest that QE may have raised the level of real GDP by 1 1/2% to 2% and increased inflation by between 3/4% to 1 1/2% percentage points.
So there you have it the transmission mechanism was that asset purchases boosted the economy via lower bond yields and that the effect was considerable. The Bank of England also put this into context with Base Rates.
would therefore suggest that the effect of QE was equivalent to a 150 to 300 basis point cut in Bank Rate,
Actually the Bank of England ended up doing more QE than analysed above. If we put aside the troubling issue that why was more needed if it was doing so well? Then we can proceed with the Bank of England view that something of the order of a 3.5% boost to GDP had been provided. Triple gins on the veranda all round!
Of course reality was not quite so convenient as the UK economy flat-lined around then which is odd considering the triumphant boost it had apparently provided! My argument is that the effect on savers and final salary pension funds sucked a lot of the boost out of the system. But if we stick with the official view we did see a shifting of the sands. Firstly we saw the use of the word “counterfactual” which was a retreat from claims of success to claiming that a calamity had been averted. Then we saw an explicit confession of failure which was the Funding for Lending Scheme of July 2012. After all if the outlook for QE was so bright why change course?!
But the official view was lower yields equals economic growth.
A side effect was that QE was supposed to boost this too according to the Bank of England.
When financial markets are dysfunctional, central bank asset purchases can improve market functioning by increasing liquidity through actively encouraging trading.
Well if I deal with the market liquidity point we hear complaint after complaint that this has reduced. Indeed the bond market “flash crash” of last Thursday was littered with complaints of a lack of liquidity. Indeed I spotted this before as the ECB began to buy up the Greek bond market that volumes collapsed and these days so many bonds are on the balance sheets of the various central banks that perhaps something similar is happening. But this is exactly the reverse of what the ivory-tower theorists promised.
What about bond yields?
Under the previous theory the recent rise in bond yields must be bad after all if lower is good it must follow. So the ECB must be shaking its head as yields are now higher than when it began its 60 billion Euros a month of purchases. Apart from this being a failure for the central planners as some form of bond vigilant operation takes place it must mean that the QE plan is not working. Well get ready for this as we set yet another theoretical somersault. From Duncan Weldon of BBC Newsnight.
Now get ready for commentary saying rising bund yields show ECB QE is failing. It isn’t. QE is policy loosening – if it works, yields rise.
Let us go with the flow for a moment. The ECB QE is therefore working after only 3 months which is something of a record! Unfortunately nobody seems to have told the ECB about this new transmission mechanism and the emphasis is mine.
Furthermore, the ECB’s interventions will reduce yields on government bonds, which will set in motion a more conventional chain of propagation channels that will support the economic recovery and help bring inflation back to levels below, but close to, 2%.
In fact Benoit Coure of the ECB Executive Board was trumpeting the falls in yields and the likely economic effect as recently as the 10th of March.
It is important to stress that some of these mechanisms are already at work. Following the announcement of the expanded asset purchase programme on 22 January, we saw a decline in the forward interest rates across all maturities, as well as a decline in government and corporate debt yields, and a rise in equity prices. For example, 10- and 20-year government debt yields declined overnight by 14 and 19 basis points, respectively, in the case of France, and by 17 and 32 basis points in the case of Spain.  Note that a relatively more pronounced effect on longer-term government yields suggests that the duration channel is at work.
Up is the new down again?
This is becoming a common feature in the credit crunch era where logic is abandoned. We saw it in the official view to credit creation where monetary policy told banks to lend whilst financial policy told them to contract their balance sheets. The UK Financial Policy Committee later did an embarassing hand-brake turn on this issue. Now we see that QE apparently worked in the UK and US because bond yields fell and is now apparently working in the Euro area because they are rising. Is it a policy for all seasons and circumstances? Is it something of a Stalinist policy where success is declared regardless of the result? I think that theorists have been listening to Genesis.
This is a land of confusion.
I think that the central planners and their acolytes might do well to consider the following lyrics from the same song.
Ooh Superman where are you now
When everything’s gone wrong somehow
The men of steel, the men of power
Are losing control by the hour.
Yes they seem to have control over short-term bond yields of which so many in the Euro area remain negative. But longer maturities are misbehaving. Perhaps they will let us know which one is a sign of success?.Sadly no doubt someone will claim both in which case it is time for Stealers Wheel.
Losing control, yeah, I’m all over the place,
Clowns to the left of me, Jokers to the right,
Here I am, stuck in the middle with you.
Meanwhile we can see one clear effect of the QE era in the news I think. From the BBC.
Picasso’s Women of Algiers has become the most expensive painting to sell at auction, going for $160m (£102.6m) at Christie’s in New York. The final price of $179.3m (£115m) includes commission of just over 12%.
The sale also featured Alberto Giacometti’s life-size sculpture Pointing Man, which set its own record. It is now the most expensive sculpture sold at auction, after going for $141.3m (£90.6m).