Central banks are giving us a “head fake” on more QE bond buying

Today it is time for a journey into what is an old stomping ground of mine which is bond markets. Actually reminders of such things have been about because this week has been the 30th anniversary of the “Big Bang” in the UK which I just made. Let me immediately point out that those 30 years have been an extraordinary bull market for bonds although there have of course been ebbs and flows. It should be a sobering thought for the latter-day central planners at the central banks that prices were rising and yields falling way before they enacted extraordinary monetary policies and QE (Quantitative Easing). However I will throw in one morsel which is that you could argue that the era of inflation targeting by central banks has turned out to be a very good one for bond investors. Frankly beyond most of their dreams. But to quote out new Nobel Lauriet Bob Dylan there are concerns that.

The Times They Are A-Changin’

A Step Back In Time

We only have to go back a few days or so to see an example of a group of investors looking to continue to front run a central bank, in this case the ECB (European Central Bank). From the Financial Times.

This week Austria sold government debt that will not mature until 2086 — highlighting the risk investors are willing to run for positive yields.

Well played to the Austrian taxpayer who saw this happen on their behalf according to Bloomberg.

The nation sold 2 billion euros ($2.2 billion) of the bunds this week, taking advantage of historically low borrowing costs.

How is that going?

A buyer of 10 million euros of the securities saw a paper loss of more than 500,000 euros by the end of Thursday, according to data compiled by Bloomberg.

As a short-term trade this has turned out to be appalling as you see it will take more than 3 years at the original yield of 1.53% to get that back or if we get a little more technical investors have felt the whiplash of what is called duration.

Its relatively low coupon and long maturity help produce a high duration factor, meaning it’s price is more volatile.

Now market prices change  but as we stand the Austrian taxpayer has played a stormer here and they have not been alone.

Before Austria’s 70-year offering, Italy, France, Belgium and Spain had sold half-century debt this year in syndicated deals — which are co-ordinated by banks.

The UK has in fact a history in this area and sold a 39 year Gilt in August and has had several goes at a 30 year one both this month and last. In fact around 4 years ago I was interviewed on Russia Today about a possible 100 year Gilt which seemed cheap then (for taxpayers) and would be even cheaper now.

This from the FT shows how brains have been scrambled by what has been taking place.

Luke Hickmore at Aberdeen Asset Management says the prices for long-dated debt look “shocking, yet at the same time they still make sense in the current environment”.

Another perspective has just been sent to me on Twitter from John Murray about the 70 year Austrian bonds.

How long’s a lifetime?

What has changed?


This returns me to my subject of Wednesday which was on the rising trajectory for inflation ( oh and if I may be so bold I did point out what a bad deal that Austrian bond was). If we stick with the inflation issue take a look at this from Germany this morning.

Now this is only a relatively minor amount of inflation but if you wished to match it to your yield then you would have to buy a thirty-year bond. Those with bonds up to the nine-year maturity would be facing negative yields as well as the inflation.

Fiscal Policy

There have been various hints of looser fiscal policy around the world. Perhaps the clearest has come from Japan where Prime Minister Abe has launched yet another stimulus although as ever some of it was in fact pre-existing. Also the UK seems to be heading that way if the latest public finances numbers were any sort of guide. The IMF started its campaign in April 2015.

fiscal policy can contribute substantially to macroeconomic stability, through the workings of automatic stabilizers. By doing so, fiscal policy can also unlock significant growth dividends.

Hard to believe that in the Euro area it did exactly the reverse isn’t it? My advice is never to buy any tyres or brakes from the IMF as the screeching U-Turns will have damaged them.

Central Banks

These have of course fed the most recent stage of the bond market boom with their interest-rate cuts and indeed their bond buying for which they invented a long impressive sounding name, Quantitative Easing. As of the end of last week the ECB for example had spent some 1.3 trillion Euros on buying the sovereign bonds of its constituent nations and the buyers of the 70 year Austrian bond no doubt had their eye on additions to the 27.9 billion Euros spent on Austrian bonds.

Now though we see that those trying to front-run such purchases are facing issues such as the supposed ECB Taper where fewer bonds would be purchased going forwards. Also the Bank of Japan seems to be replacing action with ever more rhetoric and open mouth operations. Even the Bank of England faces the issue of claiming a “sledgehammer” is appropriate for an economy which has just seen quarterly growth of 0.5% as opposed to what it told us in August.

Their current levels, if sustained, would be consistent with a contraction in output in Q3

This has led to concerns that there will be less QE and hence fewer opportunities to front-run central banks. This has been added to by the US Federal Reserve repeating its regular routine from 2016 of claiming that a second interest-rate increase is just around the corner, the same corner it has been just around since last December! We will find out a little more on that front perhaps when we get the new GDP report later.


The simple fact is that central banks have driven sovereign bond markets to completely the wrong set of prices and created a false market. This has dangers in addition to the obvious one as they have broken the economic signals and links that used to be at play. It has added to the junkie style culture where we need ever large doses of the “medicine” but the fact we regularly need another hit provides its own critique.

In my opinion they are presently trying to address this by providing a head fake. The ECB with its taper rumours and the Bank of Japan with its new strategy want yields higher for a bit. Then they will follow the model set out by the Swedish Riksbank yesterday.

Prior to the monetary policy meeting in December, the Executive Board is prepared to extend the purchases of government bonds……..The repo‐rate path now also reflects a greater probability that the rate could be cut further.

In other words they are still singing along to Trouble by Coldplay.

Oh, no, what’s this?
A spider web, and I’m caught in the middle,
So I turned to run,
The thought of all the stupid things I’ve done,

And I never meant to cause you trouble,
And I never meant to do you wrong,
And I, well, if I ever caused you trouble,
Oh no, I never meant to do you harm.

So whilst buyers of that 70 year Austrian bond exposed their investors to a barrel load of risk they may yet be bailed out by ever more QE. At which point the Jedi Mind Tricks of the central bankers will be exposed.


How is fiscal policy affected by negative yielding bonds?

This morning has started with a familiar drumbeat for these times. The ten-year yield in Germany has fallen to a mere 0.022% so not only is it being paid if it issues bonds up to nine years in maturity the benchmark ten-year is on the edge of joining it.Also it is a sign o’ the times that it is now being measured in hundredths. If we move across the border to Switzerland then this happened on Wednesday. From the Financial Times.

The Swiss National Bank has announced it will be selling 13-year bonds, maturing in June 2029, with a zero per cent coupon, its lowest fixed interest rate on record…….It seems likely that investors will be prepared to buy the debt for a guaranteed loss.

Actually as a technical issue let me correct the FT as you only have a “guaranteed loss” if you hold to maturity. In the frenzied world right now you may get a short-term profit. Even if you go out some 30 years then you are struggling to get even a 0.1% yield. I note that the average yield on both German bunds and Swiss bonds is negative which means as a broad brush they are being paid to borrow overall.

Not everybody is in that boat but the ten-year UK Gilt yield dropped to a record low 1.22% and the US Treasury Note ( ten-year) has fallen to 1.67%. So as the FT tells us.

Super low and sub-zero yields, once a source of shock, are becoming a standard part of Europe’s bond markets

I am not sure why they specified Europe as the US yields are historically very low and of course the land of the rising sun or Nihon has a ten-year yield of -0.14%. Oh and speaking of Japan.

Japan PM Advisor Nakahara: Suggests Boosting JGB Purchases To JPY100 Tln Per Year -Should Increase Easing As Soon As Next Week (@livesquawk ).

Or monetary policy meet fiscal policy or if you prefer vice versa.

What about fiscal policy?

The current situation poses some new questions for fiscal policy. There have been people in favour of a fiscal boost all along or to be more accurate more of a fiscal boost as the vast majority of countries run annual deficits. But in a nutshell the past thinking was on the lines of an expansionary policy would lead to high bond yields and possibly much higher ones should it look to be getting too high. The too high was always a bit vague with no specific levels of deficit or national debt. However A threshold did exist in the past for the UK amongst others and we saw for a while the “Bond Vigilantes” sending bond yields in the countries affected by the Euro crisis much higher. It seems extraordinary now to point out that Portugal’s benchmark bonds had a yield in the mid-teens as opposed to the 3% or so that the mainstream media tells us is a crisis now.

There are several issues to this. Let me start with simple bond management where there are two impacts. The most obvious is that it is either cheap to issue or you are paid to do it. The second is a quantity one which is you will be able to sell a lot of bonds to a yield hungry world if you nudge your yields a little higher as the Bond Vigilantes turn into Pac-Men and women. Only countries perceived to be a pretty extreme crisis will be exempt from this.

A Fiscal Boost

This has become extremely fashionable and links back to my article of yesterday when I looked at a speech made by ECB President Mario Draghi.

This is why the ECB has said many times that fiscal policy should work with not against monetary policy, and the aggregate fiscal stance in the euro area is now slightly expansionary.

He is hinting at a welcome for a more expansionary policy which gets a lot clearer if you read between the lines here.

But the orientation of other policies also influences the speed with which output returns to potential. So if other policies are not aligned with monetary policy, inflation risks returning to our objective at a slower pace.

As Mario is stamping the pedal to the metal with his monetary policy he is plainly pushing for an easier fiscal stance which is of course the opposite of past ECB advice. So many central bankers seem to take the words of Margaret Thatcher “U-Turn if you want to” as a strategic plan these days don’t they?

Japan is also switching one of the tenets of Abenomics. You see the initial fiscal and monetary boost was supposed to provide such growth that everything would be better except as the FT reported at the beginning of the month.

Japan’s fiscal situation is the worst among the major industrialised economies.Its government debt exceeds 200 per cent of gross domestic product — worse than Greece.

In fact in the Abenomics fantasy world reality appears to have disappeared.

Mr Abe said during a press conference on Wednesday that he would not change a target of achieving primary balance surplus in fiscal year 2020, but how he can meet this goal is now unclear.

So a fiscal consolidation becomes a fiscal boost but don’t worry as the future is bright! Sadly like in the UK the fiscal future that is bright is 3/4 years away whenever you start from.

Germany Japan and Switzerland

These three countries could undertake a fiscal boost right now and be paid to do so. They would be better off in annual terms by doing so. Firstly let me give you some musical accompaniment to this idea from OMC.

How bizarre
How bizarre, how bizarre

There are even a couple of lines from the song for the Bond Vigilantes.

It’s making me crazy
(It’s making me crazy)

So Germany could borrow and boost the Euro area in a way that those who argue against imbalances would consider as Christmas come early. Switzerland could do the same and again boost the Euro area. Japan could join in or to be more specific it could add to its existing fiscal boost and hope that doubling-down again would work and likely be paid to do it.

GDP Linked Bonds

Jens Weidman of the German Bundesbank has highlighted this today.

zero-risk weighting of sovereign debt distorts capital allocation and therefore acts as a drag on growth…..Doing away with sovereign debt as a cluster risk would also pave the way for the orderly restructuring of sovereign debt

At first sight he is saying how silly the current situation is although avoiding the fact that the ECB of which he is (mostly) a voting member has driven it both theoretically and practically. So the suggestion is as follows.

A recent initiative by the Bank of England is pushing for the introduction of standardised GDP-linked bonds. By tying coupon payments, and potentially the principal as well, to a country’s growth rate, investors share both the upside and the downside risk of a country’s economic development.

You may recall this was suggested for Greece back in the day and investors can let out a sigh of relief it never happened as the ongoing economic depression would have made their investments take an ice bath. For Germany right now it would not far off define insanity but there are problems. The Bank Underground blog unwittingly helps us out.


What could go wrong?

Let me throw in another problem which is changes to GDP itself. In the last few years the UK has made several by changing its inflation definition ( worth around 0.5% per annum of “extra” growth) and the ESA 10 changes such as drugs and hookers as well as double counting Research & Development which was worth around 4%. A nice windfall for those in the know?


Negative yielding bonds provide quite a windfall for fiscal policy. There is a flow one which the media mostly ignores but there is the opportunity for a capital one should the 3 main beneficiaries use it. It is not quite a “free lunch” although it would be for a while a lunch that you were paid to eat. What I mean by that is that the national debts would rise and also the bonds would as a minimum have to be refinanced in the future and maybe in some sort of alternative universe – the sort of place where Spock in Star Trek has emotions – be actually repaid.

So thoughts?

Where next for the economy of Saudi Arabia?

A clear economic feature of the last year or so has been the spectacular fall in the price of crude oil. In spite of the recent bounce the price of a barrel of Brent Crude Oil has fallen by some 51% over the past year to US $49 per barrel. This represents quite a transfer of income and wealth from the producing nations to the consuming ones. I noted an estimate on CNBC a week or so ago of between US $900 billion and US $1.3 trillion which seems on the high side to me. Today I wish to look at the impact on the nation which in oil terms at least is most associated with its price and outlook and that is Saudi Arabia.

The Budget is tightening

In many ways being Saudi Finance Minister must have seemed one of the easiest jobs in the world! After all the price of the country’s main resource crude oil remained with one brief exception over US $100 per barrel from early 2011 to the latter part of 2014. Thus the revenue gushed in. The Persian Gulf Fund put it thus a few years back.

Saudi Arabia has the biggest oil reserves in the world and it is the second largest oil producer after Russia. Oil production gives 40% of the country’s GDP and as much as 80-90% of its budget revenue, which means that Saudi Arabia’s ability to spend money is quite directly associated with oil prices.

According to the International Energy Agency Saudi Arabia produced 13.1% of the world’s oil based hydrocarbon supply in 2013 and was by far the largest exporter in 2012 with some 371 million tonnes or 18.7% of the world total. Of course between then and now has come the shale gas and oil revolution especially in the United States but for quite some time the oil based revenue situation for Saudi Arabia could hardly have been more favourable.

This morning however on CNBC the Saudi Finance Minister Ibrahim al-Assaf said this.

We have built reserves, cut public debt to near-zero levels and we are now working on cutting unnecessary expenses while focusing on main development projects and on building human resources in the kingdom.

He was deliberately vague about what expenses are now considered unnecessary but there is a clear change of emphasis and tenet. Also those who follow the Jim Hacker line of “never believe anything until it is officially denied” will find the next bit to be ominous. From the BBC.

Talking to broadcaster CNBC Arabia, he said the country was in a good position to manage low oil prices.

What about the reserves?

Saudi Arabia built up a strong position in terms of foreign exchange reserves which peaked at just under 2.8 trillion Riyals in August 2014. However the figures for July of this year (the latest) show that they have declined to 2.51 trillion Riyals. So plenty left but a hint that not even Saudi Arabia can carry on regardless for ever with a lower oil price.

A pegged exchange rate

Linked into the situation with the reserves is the level of the Saudi Riyal exchange rate which was pegged to the US Dollar at an exchange rate of 3.75 to 1 back in 2003. Here we see one of the weaknesses of a pegged exchange rate as the strong US Dollar has taken the Riyal with it just when it would have fallen and probably considerably in response to the fall in the oil price. An example of this has been the Russian Rouble where it now takes 68 of them to buy one US Dollar as opposed to the 37 of a year ago. Now there are all sorts of consequences from a plummet in your exchange-rate of that size with inflation being the most obvious but the only exchange-rate flexibility Saudi Arabia currently has depends on what happens to the US Dollar via the US economy. I guess they too are wondering what the Federal Reserve will do next week!

There has been speculation that the peg will be abandoned and several times this year it has come under pressure. But as you can see from the size of the reserves about Saudi Arabia can hold it for quite some time if it wishes.

Saudi Arabia has tended to overspend

As the money has flowed in then Saudi Arabia has not really needed to maintain much of a grip on public expenditure. The US-Saudi Arabian Business Council tells us this about last year.

Expenditures, originally estimated at $228 billion (SR855 billion), stood at $293.3 billion (SR1.1 trillion).  This increase is 28 percent above the budgeted level but not significantly higher than the average amount of overspending recorded over the last ten years.  This resulted in a budget deficit of $14.4 billion (SR54 billion) in 2014.

Food for thought there as we note that in what were much more favourable times there was a deficit albeit a small one. This was in spite of the fact that revenues were yet again gushing in.

While the 2014 budget originally envisaged revenues of $228 billion (SR855 billion), they actually amounted to $278.9 billion (SR1.046 trillion).

Many countries including my own would love that revenue situation! But of course the picture for 2015 looks very different if the year to September is any guide to the rest of it.

Saudi Arabia has set a state budget for 2015 with total revenues projected to reach $190.7 billion (SR715 billion) and total spending valued at $229.3 billion (SR860 billion) which is expected to result in a $38.6 billion (SR145 billion) deficit.

If we look at the way that the country overspent last year then one immediately wonders how much of an overspend there will be this and thereby how large the deficit will turn out to be. Last month the IMF pitched in with its estimate on the situation.

A central government fiscal deficit of 19.5 percent of GDP is projected in 2015, and while the deficit will decline in 2016 and beyond as one-off spending ends and large investment projects are completed, it will remain high over the medium-term.

As ever with the IMF it is about to get better! The real question if we look at the obvious political issues in the region is whether Saudi Arabia will feel under pressure to spend even more.

What about issuing bonds?

You can imagine that this has not been a Saudi priority for some time. But as Bob Dylan put it.

Then you better start swimmin’
Or you’ll sink like a stone
For the times they are a-changin’.

More prosaically Trade Arabia puts it like this.

Moreover, for the first time in eight years, the government is also expected to issue local bonds worth SR115 billion ($30.7 billion) through the second half of 2015 to cover around a third of the deficit.

This is underway as just over US $5 billion of bonds were issued a month ago. It is also true that there is plenty of scope to issue them as the IMF points out.

Nevertheless, government debt is very low and was 1.6 percent of GDP at end-2014.


So there are fiscal troubles in Saudi Arabia leaving it with a choice. One is to continue with its spending plans and support GDP growth in a manner similar to Keynesianism. The other is to take the IMF style approach and to cut back in a more austere manner. In some ways the IMF has a cheek as whilst exports have fallen Saudi Arabia has had many years of balance of payments surpluses.

As to the underlying economy it grew by 3.5% last year and have just seen this on the money supply.

Broad money supply (M3) rose by an annualized 10.5 per cent in June, indicating continued expansion of economic activity, said a report in Arab News, which cited NCB’s Saudi Economic Review for August 2015.

However this is also true.

the pace of annual growth has been in deceleration since the beginning of the year,

Thus there is something of a squeeze going on and I am reminded of the lyrics of the Clash.

The oil down the desert way
Has been shakin’ to the top
The Sheik he drove his Cadillac
He went a-cruisin’ down the ville