The ECB, QE and the waiting game

12 Feb 2015

Quantitative easing is a process by which a central bank buys relatively safe assets (mostly government bonds) and thereby puts cash into the hands of the newly-ex owners of those assets. In the early years of the financial crisis, this was effectively a life-support system for financial institutions which, post-Lehman Brothers, looked like they might fall domino-style. As the central bank bids up asset prices it creates a rising tide that floats many boats. One side effect of this is that the wealthy become wealthier.

QE is quite tricky to justify from this point of view. If it is necessary to prevent the collapse of the banking system it is a jagged pill that needs to be swallowed. As I have written before, this is broadly how the Bank of England justified QE in 2009.

“Purchases of assets by the Bank of England could help to improve liquidity in credit markets that are currently not functioning normally.”

But gradually, while the music remained the same the lyrics changed. Expressing an idea that was essentially imported from the US, the justification from the Bank in 2011 was quite different.

“The purpose of the purchases was and is to inject money directly into the economy in order to boost nominal demand.”

You see what they did there? Once again, it was party time in financial markets. Bonds and equities were rising nicely. Bonds were rising because the Bank was buying them and other people were buying them because the Bank was buying them and equities were rising because they looked cheap compared to bonds. And property in the areas where financial people live began to go up again, despite the fact that prices appeared to require mortgages that quite high incomes could not plausibly service and that damaged banks could not reasonably be expected to offer.

My friends and I have done splendidly from this once we had “got it”. And although I don’t know any influential people, some of my friends do. Call me a conspiracy theorist if you want but these influential people soon popped up all over the place saying how brave and wise central bankers were to extend QE.

THE HIGH MORAL GROUND IS EXPENSIVE REAL ESTATE

A few people didn’t get it. Here is a very clever hedge fund manager, Hugh Hendry, in an interview late last year.

“I found myself unable to forgive the Federal Reserve and the other central banks for, if you will, bailing out Wall Street from the excess of 2008. I just couldn’t get over it. I luxuriated in the polemics of Marc Faber and James Grant and Nassim Taleb, in our own country, Albert Edwards, et al. I luxuriated as they ranted and it was fine for them to rant. But I am charged with the responsibility of making money and not being some moral guardian and certainly not a moral curmudgeon. I had to get over that.”

As Hendry implies, QE is awkward and arguably immoral. But it is popular with relatively rich people who want to become relatively richer. Consequently, it is very helpful to say that the monetary extravagance of QE will trickle down to the rest of the economy, even if you are not sure that this is the case.

The ECB has now joined the QE club and will spend €60 billion a month on Eurozone sovereign bonds. Here is the reason (from its own press release)

“Asset purchases provide monetary stimulus to the economy in a context where key ECB interest rates are at their lower bound. They further ease monetary and financial conditions, making access to finance cheaper for firms and households. This tends to support investment and consumption, and ultimately contributes to a return of inflation rates towards 2%.”

When the supply of anything booms, its price tends to fall. QE is testing this logic in the spirit of Dr Frankenstein and his monster. In a curious echo of the sub-prime crisis, it is hoping that banks and other financial institutions will respond to the most unattractive lending rates in history by increasing their loan books. What would you do? No, me neither.

The ECB is targeting a recovery in inflation (currently at -0.6%) effectively by bidding up the prices of financial assets. That sentence contains the words “prices” and “up” so maybe that’s a start. Here is Hugh Hendry again.

“Wages are still not moving. Prices are still not moving. If anything they’re moving the wrong way. Europe needs high equity prices and high animal spirits and then you’ll get people feeling more confident about the collateral. The banks will be more willing to lend and slowly, but surely we will re-engage, and we will get growth, perhaps, on a par with what we’re seeing in America today.”

This one-time “moral guardian” has thrown in the towel as far as he can chuck it. High animal spirits are indeed rampant among people who already own assets like equities and property. We are doing what the central banks are asking us to do. We are becoming wealthier by sitting on our rapidly spreading backsides. Now we must do the moral thing and consume. That’s all that is asked of us.

As a cunning plan to reignite the world’s economy I think it must be clear to many people that this is pretty lamentable stuff. It is hard to suppress the idea that there will be an ugly reckoning at some point.

The ECB’s asset purchases will, thanks to German lobbying, mostly consist of national central banks buying the bonds of their own governments. We can assume then that the biggest player will be the Bundesbank buying mountains of paper with negligible yields. If you own 30 year Bunds yielding 0.9% the chances are that you are a fairly cautious fellow. In fact, if that truly reflects your view of economic growth for the next three decades, you are probably clinically depressed. If someone buys your Bunds for cash, which of the following three things are you most likely to do?

1)      Start up a fashionable lifestyle business.

2)      Go on the holiday of a lifetime.

3)      Guard your savings with your life.

The danger is that this belated QE looks desperate and desperation does not promote confidence.

But let’s get back to the ugly reckoning.

Many European banks are still zombies, supported by the original objective of QE (to prop up the prices of their dodgy assets) but with regulators being belatedly demanding about their capital adequacy. As noted above, banks are generally reluctant to re-grow their balance sheets with loans at historically low interest rates.

THE SCARY SHADOW BANKING SYSTEM

So much for banks. What about the well-named shadow banking system? In a speech in 2013 the then head of the Federal Reserve, Ben Bernanke described it thus:

“Shadow banking comprises various markets and institutions that provide financial intermediation outside the traditional, regulated banking system.”

Much of shadow banking consists of securitizing assets and using them as collateral for loans. If that seems vaguely familiar, yes such activities were indeed at the root of the financial crisis.

As we know, in 2007, sub-prime mortgages were used as security for toxic bundles of AAA-rated defaults. You might wonder how the world could so soon be so stupid again. But in 2013 it was reported that vast amounts of copper that had been stockpiled in China were being used as collateral for shadow banking loans. Copper is of course a commodity whose price can be volatile. It has dropped by more than 40% since 2012. Did that matter? A partial answer is that we won’t know until it goes wrong.

As you would expect, central bankers worry about the systematic risk of vast amounts of unregulated lending. Effectively, if counterparties start defaulting due to excessive leverage and a collapse in the price of the assets that have been securitized, we could be back to that scary game of financial dominoes. And the Chinese copper story illustrates the scale of the task.

The recent steep fall in the prices of oil and other commodities has raised the question of whether the borrowing has been funding extra productive capacity that will now be uneconomic. In the last year, crude oil, as we know, has fallen by 40%, diesel by 33%, natural gas by 18%, rubber by 37%, palm oil by 22%, rice by 8%, wheat by 7%, copper by 10%, tin by 13%, silver, which has an industrial use, by 17% and gold, which does not, by 2%.

It looks like a very deflationary world in which last year’s dollars were invested in pursuit of returns that look as if they will be below expectations. The only mitigating factor is the dollar itself which has risen by c.17% against a basket of currencies in the last twelve months. Commodities are priced in dollars so these declines will look much less alarming in most other currencies. It can be argued that the revaluation of the dollar is a logical and rebalancing mechanism against trends elsewhere in the world’s economy.

So we seem to be in a contradictory position. QE in the US, UK, Europe and Japan is providing very limp conventional economic stimulus but the relentless low interest rate environment appears to have caused another boom in unregulated lending, which has substituted for regulated lending by banks.

Quantitative easing has created a sclerotic world in which the fall in asset prices that might be expected to follow a dramatic economic decline was averted. As we know, this was done in order to save the banks but it deprived modestly cash rich or credit-worthy people of the opportunity to buy cheap assets. In London in the early 1990s the credit-worthy had the opportunity of a lifetime to buy property. From late 1990 to late 1992 consumer prices rose by c.10% and UK property prices fell by c.10%. It took 26 quarters, until 1997, for prices to return to the 1990 levels.

Something more dramatic happened in late 2007 when UK property prices fell 14% from their peak. We braced ourselves for more bad bank loans and negative equity. But then QE kicked in. Peak prices were hit half a year quicker than they had from the much milder 1990s recession and then accelerated. In that sense the Bank of England probably feels very pleased with itself. But the result is that people who already owned property were bailed out and the generational opportunity cost was that younger people who might have taken advantage of the slump were once again priced out.

Many people would welcome a sharp correction in property prices. As long as it were not accompanied by a rise in interest rates it should mean that demand for property would at some point kick in from new buyers. It would be bad news for those who regard their home as their pension but if it kicked them into selling up that would at least rebalance some of the nation’s wealth back towards younger generations. 

WHEN THE RECKONING GETS UGLY

This is an investment blog not a moral rant. But rules or practices that promote one group over another are probably unsustainable in a democratic country. The problem that we see in many countries now is that the asset-rich (sometimes through no fault or act of their own) possess a growing share of accumulated national wealth. This leads to a rise in the popularity of ranting politics, both on the left and the right. In Greece this has resulted in the election of a government led by a man who (favourite fact) named his son in honour of Che Guevara .

I have a great deal of sympathy for Greece (on the grounds that irresponsible borrowing is impossible without irresponsible lending) and I have no strong opinion about whether they can work out a solution that keeps them in the euro. Greece is a sub-prime and shadow banking crisis embodied in one nation. Its ugly reckoning has been provoked by the fact that foreign creditors have no compunction about demanding repayment at any cost to the debtors. (Remember the UK government using anti-terrorist legislation to freeze the assets of Icelandic banks in 2008?) Let’s hold that thought and see where it applies in the rest of the world.

The shadow banking system could ultimately involve a similar mismatch between lenders who have no common interests with borrowers. It is hard to predict how or where this might play out because shadow banking is mysterious per se. But distressed liquidation of assets is always expensive. Greek shares are down by 31% in the last year.

By contrast, although the financial position of Japan looks terrifying on paper, almost all Japanese debt is held by Japanese institutions or citizens. The common ground between debtor and creditor is vast. Consequently a position that many felt unsustainable (Japanese government debt to GDP is 227% compared to c.175% in Greece) has persisted for years and years.  

Let us return to the possible ugly reckoning for UK assets.

The essential gift of QE has been to lift asset prices to unaffordable (property) or unattractive (bonds) levels. This disadvantages earners who cannot buy a house and savers who cannot buy a viable income or a pension. At some point it is reasonable to suppose that these gaps must close.

Keynes famously wrote that “in the long run we are all dead”. His point was that an economist’s use of “the long run” was often useless to current policy. But in this case, the Keynes quote may be pointing us to exactly the right place. Many UK homeowners will die owning their houses and much of government borrowing is financed by selling gilts that will outlive the people who buy them. Without some external party to call “time”, this gap between the few who own most of the assets and the many could persist or, alarmingly, widen.

The Bank of England continues to hold £375 billion of assets, mostly gilts, apparently to the satisfaction of most public commentators. Whenever a gilt matures, the proceeds are reinvested. The Treasury scoops c.£14 billion a year from dividends earned by the gilts held by the Bank’s APF (asset purchase facility). Naturally, the fact that this income will eventually have to be paid back (by making good the losses on the gilts, mostly bought way above par) worries no politician now. They or at least their political careers will be dead when that happens.

DO OUR FOREIGN INVESTORS THREATEN THE UK?

Foreigners own a gently declining proportion of gilts (28%, down from c.30% two years ago) but it is hard to see why there would be mass selling – the UK looks like a relative haven from an international perspective and the recent rally in sterling against the euro implies that the pound is attracting money that has gratefully jumped ship from the Swiss franc.

Foreigners also notoriously own much up-market London property. Their demand has caused an outbreak of new “luxury” apartment blocks in areas that are not considered very smart by the indigenous population but which are seemingly being successfully sold off-plan in places like Hong Kong.

It could be that foreign investors will abandon the UK but, as ever, we need to ask where they will go instead. Magna Carta, which is tenuously but widely regarded as the foundation document protecting the rights of the individual against the state, is 800 years old this year. Foreigners are understandably impressed and they plausibly believe that if they become owners of an asset according to UK law, they will be protected from having that asset confiscated on the whim of a despotic politician. If that asset happens to be a waterside apartment from which, with binoculars, it is just possible to see the Houses of Parliament, so much the better.  

I am not expecting foreign investors in UK assets to cash in anytime soon and, despite whiny lobbying by American investment banks, they will probably be quite indifferent to whether the UK stays in the European Union – they might even view an exit as evidence of the stout bulldog spirit.

British homeowners or the beneficiaries of their estates will have to sell their assets one day. In real terms the price of property will have to fall to come within the scope of average incomes if they are to sell to domestic residents. And do not forget that the future incomes of new university graduates will be raided by the egregious interest payments on their student loans. One could argue, and I would be happy to do so if anyone would listen to me, that young people might be happier spending their income on living rather than saving for the deposit on a property situated in the nether regions of the property ladder.

As I have written before, a serious increase in the inheritance tax exemption threshold by base, vote-seeking politicians could create a class of property owning families within which one generation could pass houses on to the next. Assuming that this social disaster is averted, I can imagine a rise of property owning companies that take on portfolios of houses being sold by executors. This would reverse the dream of home ownership that much of the British public has come to regard as its right, but it would stay the property crash that terrifies the people who have realised that dream.  

The UK’s ugly reckoning looks a long way off once you put aside your moral disapproval. The general election in May looks divisive in a fragmented rather than a polarized way. Whatever government emerges will probably be either a thin majority or a coalition. Someone will bleat that “markets hate uncertainty” and then the government will be declared limp and ignored.

Europe has now joined us in waiting for QE to stimulate the economy. I think that there will be more waiting that stimulating, if I can put it like that. People who make big calls are usually impatient by nature. Magna Carta is 800 years old. While we wait, let’s do our patriotic duty, stop fretting about saving and spend some cash while we still have lives to enjoy, if only to pass the time.