So now the argument is that QE works whether it reduces or raises bond yields?!

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.

Market Liquidity

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.

What changed?

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. [5] 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?

Comment

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).

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23 thoughts on “So now the argument is that QE works whether it reduces or raises bond yields?!

  1. Hi Shaun
    I continue to be amazed how you so brilliantly put together such well considered critiques of a fundamental ‘truth’……’they’ lie!
    All the CBs have been doing since 2008 is keeping the commercial ‘zombie’ banks alive, which incidentally has enriched the already rich and squeezed just about everyone else. Thus allowing the debt driven slow decine of ‘developed’ nations to be managed without too much social upheaval.

    • Hi JW and thank you.

      We now know the lengths to which our establishment will go to back the banks. As The Eagles put it “Take It To The Limit”. However the ability of much of the media to claim they are offering analysis when they are either toadying or copy and pasting official communiques seems to go even further!

  2. Hi shaun
    So we have Peter Ustinov’s aston at £1.5m, a
    painting by Von Klump at $89m and yet gold is
    $1184 an ounce, Ermmm.

    JRH

    • Hi JRH

      Yes the point about gold is well made. You might think that negative interest-rates and yields would make it more attractive and drive the price higher.

      Also let me add in Bitcoin which at US $244 is now really responding either.

  3. As with every other politico-economic strategy, look at who is profiting in order to cut through the lies and get to the true purpose.
    Politicians aren’t as stupid as they’d have you believe; after austerity “failed” in country after country, to pursue it would be stupid, right?
    Not if its aim was other than stated.
    Similarly QE.

    • Austerity has worked in Iceland. I do not see any other country walking the austerity walk – giving billions of subsidies to banks is NOT austerity.

  4. Good post Shaun, although in reality what you are pointing out is how loose policy makers are with the truth. You do win a prize for being the first commentator for musing on the $179m painting concept – who/why?!!!

    After several years in derivatives I decided to teach economics (“I’ll stop the policy makers pulling the wool over your eyes”) and this very morning I was berating an A2 student for glibly claiming that QE forces bank lending to the “real” economy; it won’t surprise you to hear that the exam is probably marked by left-leaning/authority-compliant Keynesians who could not take the truth as you lay it out. I do hope questioning all this comes under “Evaluation” for the A2s – after all, we are supposed to be providing an education, aren’t we?

    Keep up the good work.

    • Hi Joss and welcome to my corner of the online world

      I welcome the fact that you are providing some teaching which applies outside of ivory towers! I see the writings of various Professors and some contact me via Twitter and so on. I am afraid to say that little has been learnt and I worry about what is being taught. After all chapter after chapter of economics textbooks was contradicted by the credit crunch and yet the same old stale thinking keeps popping back up.

  5. I am happy for oligarchs to “invest” their squillions in art as when the crash comes their “investments” will be worth much less and a lot of their money will have been wasted. That should level the playing field a little.

    • Hi Jan

      A good point! But these days losses seem to always involved some form of socialisation and bailout so maybe we should be careful what we wish for?! Also if the choice is the lot being confiscated by Putin at his whim maybe you would not be too upset if you can get the money outside of his reach. Abramovich and Chelsea comes to mind also……

      The game gets ever more complex.

  6. The central banks remind me of a typical Dr Who episode where the doctor runs around the console in the Tardis, frantically pulling levers, pushing buttons, shouting at the console while the console short circuits all to no effect as the Tardis is in free-fall. Then no matter where it lands in time or space he declares that this is exactly where he intended to land, he had planned it all along and didn’t he do a good job.

    • Hi Pips

      But the good doctor has saved the universe so many times! Our QE crew by contrast have to keep changing their explanations as they are struggling simply to save the banks.

      Actually we could do with someone like Dr.Who to rescue us from an establishment in thrall to the banks….

  7. Mish Shedlock is always banging on about the law of unintended consequences.The thinking behind QE never seemed to include any appreciation of the fact that whilst QE would bail out those sinking under big debts and the banks,it would also stop savers spending.

    The proof of the pudding is in the velocity figures.

    • Hi Dutch

      It is also important to remember that the western central banks ploughed into QE with the evidence being from the Bank of Japan that it had so far failed. I think that once they had cut short-term interest-rates as far as they felt that they could then the pressure to “do something” became too much for them. Now they need to claim it as a success….

    • I suspect QE thinking was based on the knowledge that the UK/US etc are private domestic/business and public debt based economies. So, the reduction of lending rates would bvenfit the majority and stuff the minority savers. Unfortunately, the BOE can’t control what he banks do and they decided to reduce mortgage rates (after much enciuragement via FLS and HTB) but maintain personal/busimess loan rates nad credit card rates at old levels. You can’t blame them really, they’re focussed on rebuilding their balance sheets and meeting Basel III requirements.

  8. What really worries me is that no central bank is attempting to reign in their emergency measures and some are even increasing them whilst economies are improving. What are they going to do next time there is a crisis? There’s nothing left! All central banks should agree a balanced programme of getting back to ‘normal’ interest rates and reducing QE levels. It has to be an agreed programme to keep exchange rates roughly in balance. As it is they are all terrified of the consequences of a move on their own and the impact on their domestic economy. The consequences of not ‘fixing the roof whilst the sun shines’ is that they will be forced to sit on the sidelines if the global market is hit by another major upset.

    • Hi Pavlaki

      The point you make is a really big one in my opinion. How will we ever get off the “junkie fix” if even in the supposedly good times we need an ever higher dose? The continued expansion of QE in Japan or QQE is not going well and what happens if they buy all the available JGBs? Then Japan has another slow down…

  9. Hi Shaun, I think you are able in showing that the transmission mechanism is now right royally broken. For novice economists like myself I like to see the price and yield relationship clearly and inversely trending but this boat rocking is making me sick. QE is a drug that keeps those well meaning authorities in charge but as you often show it is one with unpredictable side effects…
    Later is the week please can you explain the theatre of Grexit, based on all forecasts the Greek Nation’s coffers should be empty of Euros however an “order” to their treasury today resulted in paying the IMF with SDR’s that the IMF had granted them. Now this sounds better than QE, those SDR’s look really elastic. Can we have some in the UK please?

    • Hi Paul C

      As to the numbers the UK Quota at the IMF is around ten times that of Greece so in theory we could borrow such a sum for a month or so. Why would we is the question though?! There is around a month to repay this which is where it gets awkward as Greece has 3 other repayments to make to the IMF in June. So can kicking of only a month? That looks not a little desperate doesn’t it?

      I am sure that Greece will be along again soon.

  10. Hi Shaun, Brilliant stuff. Thanks.
    Lewis Carroll must be required reading at the BoE.

    ‘When I use a word,’ Humpty Dumpty said, in rather a scornful tone, ‘it means just what I choose it to mean — neither more nor less.’
    ‘The question is,’ said Alice, ‘whether you can make words mean so many different things.’
    ‘The question is,’ said Humpty Dumpty, ‘which is to be master — that’s all.’

  11. Hi Shaun,this is a great post. I’m new to this realm so I’m still being fed the “QE lowers yield” views – what about the truth of QE? I saw someone mentioned bank subsidies earlier; would you mind elaborating that a bit?

    Thanks.

    • Hi Helen
      Thank you and welcome to my corner of the online world.

      I could write whole articles on this subject but let us start with the lower yields issue. The QE era has been associated with lower bond yields but has it been the cause. It is easy to think that so much buying must have had an impact but Japan and in the last week or so the Euro area have seen bond yield rises in the face of large purchases.

      The bit that has subsidised the banks is the asset purchases themselves. In essence it had bid up the prices of the banks assets. Some of this has been indirect but some direct such as the ECB buying covered bonds and the US Federal Reserve buying mortgage backed securities

  12. “What has happened to the central planners and is the pot boiling over.” Perhaps they’re letting the markets do their work for them? Then they can adjust base rates to natural market levels – Fed will be first to move this September/October and “You might think that negative interest-rates and yields would make it more attractive and drive the price higher.” Really? With a relatively strong dollar??

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