How I Learned to Stop Worrying and Love QE

How I Learned to Stop Worrying and Love QE

3 Jul 2013

The recent correction in world stock markets was widely attributed to comments made by Ben Bernancke on 22 May, such as this:

Asked whether the Fed would curtail the pace of its bond purchases by the September 2 Labor Day holiday, Bernanke said simply: “I don’t know.”

The word of the moment is “taper” meaning “to reduce gradually” indicating that one day the Fed will buy fewer long dated assets through its QE programme until the day arrives when it will buy none at all. This vague prospect is thought to have caused the US S&P 500 to fall by 6%, the FTSE 100 by 12% and the Japanese Nikkei 225 by 20%.

In theory QE might be reversed. Instead of being a buyer of assets the Fed might dispose of them as confidence rises. That day is hard to imagine now, given the panic that would presumably ensue. Financial markets in the US speak very loudly to the senior executives of the Federal Reserve and the recent historical evidence of the latter standing up to the former is negligible.

This implies to me that QE asset purchases are likely to be strung out for as long as financial credibility permits and that many of the purchased assets will be held to redemption. The persistence of QE provides short-term gratification to financial markets (the words “short-term” are probably redundant – markets know no other kind of gratification) but as I have argued elsewhere it probably has a negative effect on the rest of the economy – liquidity turns to ice when its primary purpose is to prop up zombie banks.

All this and more applies in the UK.

The Bank of England’s relationship with HM Treasury (effectively the government of the day) has long been the subject of interesting debate but in practice it has been subjected to increasing statutory control since it was nationalised by the Atlee government in 1946. The Blair government famously gave it the power to set interest rates, a move that was spun as allowing it to pursue monetary stability independent of interference from politicians. Yet, read the bank’s own summary of that 1998 act:

In 1997 the new Government announced its intention to transfer full operational responsibility for monetary policy to the Bank of England. The Bank thus rejoined the ranks of the world’s “independent” central banks. However, debt management on behalf of the Government was transferred to HM Treasury, and the Bank’s regulatory functions passes to a new Financial Services Authority.

The second sentence is the “money” part of the quotation. We all have an opinion about how the appropriation of the regulatory functions worked out but let us not ignore the formal placing of debt management with the government of the day. As far as issuing debt is concerned, the Bank of England is not the Treasury’s banker but its broker. It has been eased from an advisory role to one of little more than execution.

The Bank began buying gilts in March 2009, authorised, needless to say, by the Chancellor of the Exchequer. It set up an Asset Purchase Facility (APF) which formally borrows at 0.5% from the Bank itself, thus establishing its identity, in theory, as an independent unit. Even with gilt yields as low as they have been, borrowing at 0.5% and buying bonds yielding 2% or 3% is dull but nominally profitable business. Or rather, it was until November 2012 when it was found to be “economically inefficient”.

The reason why it was “economically inefficient” was that the government can only pay the interest on its own (i.e. our) debt by borrowing more. Therefore it was borrowing to pay interest on debt owned by an institution (the Bank of England) that it ultimately owns. The dividends accumulated by the APF were consequently deemed excess cash that could be paid back to the Treasury.

The net “excess” dividends are expected to be at least £11bn this year (source: the Office for Budget Responsibility). Until the gilts reach redemption or are sold, this income will continue. If the APF is expanded further, it will grow. For the Chancellor this must look like free money. There is a small chance that a politician responsible for hugely and increasingly indebted public finances will turn down free money and if anyone is prepared to offer me odds of a million to one I will have a small bet on it.

While I wait for the offers to roll in, I make this observation: that the government has a material interest in keeping QE going. In 2009, QE was seen as what I believe it is – a measure to rescue the banks from the potential consequences of their leveraged folly. As the Bank of England said at the time:

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

When the QE facility was extended in 2011, the message had changed somewhat:

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

The official line now is that QE is injecting money directly into the economy. That is a highly debatable point, in my view. What is beyond dispute, though, is that it is injecting money directly into the Treasury. If you are Chancellor Osborne with a new hand-picked Governor of the Bank of England, what’s not to like?

I have said that repayments of gilt coupons to the Treasury look like free money. Obviously, this is not the case. In November 2012, when this policy was introduced, Mervyn King, the Governor of the Bank of England at the time, wrote to the Chancellor as follows:

While transferring the APF’s net income to the Exchequer will result initially in payments from the APF to the Government, it is likely to lead to the need for reverse payments from the Government to the APF in the future as Bank Rate increases and the APF’s gilt holdings are unwound by the Monetary Policy Committee (MPC). Indeed, under reasonable assumptions it is likely that the majority of any transfer of funds to the Government will eventually need to be reversed.

The essential point is that, shorn of the income, the APF is likely to make significant losses on its gilt holdings. These will be covered by “the Government” according to King’s letter. To put it another way, the losses will be covered by taxpayers in the future. As usual, the politicians’ favourite voter is the one who will be voting for their successors. A very long-suffering but uncomplaining chap, he is.

Given that there is no incentive for the Treasury to unwind QE, I expect that it will die a very slow death as the gilt holdings reach their redemption dates. On that basis I can say exactly what the losses will be and when they will occur. I know this because all the gilt purchases are published and almost all of them have been bought well above the par price at which they will be redeemed. On average, the APF or rather the Bank or rather the Treasury or rather the taxpayer will lose c.15% of the gross sum invested. As of today, that just over £49bn with the losses distributed over time as shown on the chart. Anyone think that George Osborne will be Chancellor  when the annual loss peaks at £6.2bn in 2021? Nope.

Gilt losses


The independent forecast from the Office of Budget Responsibility (OBR) concerning the unwinding of QE in the UK is entirely different from mine (and extremely implausible in my view):

Our central forecast assumes that the Bank makes gilt sales of £10 billion per quarter from the middle of 2016, when the market expects Bank Rate to have returned to 1 per cent. This implies that QE would be unwound by late 2022, thanks to roughly £250 billion of gilt sales and £125 billion of redemptions In total, under this set of assumptions, the Exchequer is projected to receive around £73 billion up to 2016-17, but then pay out around £18 billion over the following years.

The OBR’s version of events would deprive the Treasury of income and would probably upset market sentiment. Gilt sales are highly unlikely to happen against the wishes of the Chancellor of the Exchequer, whoever he or she is. Note also that the raising of the Bank Rate would also cut Treasury income because the “excess” profit repaid by the APF is net of the notional cost of its capital which is the Bank Rate, currently at 0.5%.

Consider that Bank of England’s Monetary Policy Committee is currently split 6-3 against expanding QE with the retiring Governor in the minority in favour of increasing it. The new Governor Carney is regarded by the press as even more in favour of QE expansion and is, rightly or wrongly, expected to have more influence on the antis.

Once again, short-term expediency appears to be being promoted at the expense of future generations – once again, the unspoken mantra is “let the children pay”. Despicable as that is, this is not supposed to be a ranting blog. The issue for this website is investment decisions and if I am correct that QE will outlive many of us, the implications challenge many of today’s commonly held assumptions – and that should add up to opportunity.

Your bog-standard talking head, if I can put it like that, thinks that government bond yields are too low and will rise as the economy recovers and inflation picks up. The trend of falling gilt prices will be exacerbated by the unwinding of QE as the APF turns seller.

If anyone out there believes that the Bank Rate will not be raised and QE will not be unwound for a very long time, I have not heard or read them. On that basis alone it is worth considering whether any investments based on the probability of that outcome are under-priced. Improbably, this seems to point straight back to gilts.

I have been negative about gilts and have been in plentiful bog-standard company and largely correct. The yield of 10 year UK government bonds troughed at a seemingly ludicrous 1.5% in July 2012 but rose to 2.5% last week. If you are expecting economic recovery, a higher Bank Rate and a possible pick-up in inflation, 2.5% still doesn’t sound particularly attractive.

Yet, in my view, there is an interesting counter-argument. The Bank of England has undoubtedly pushed gilt prices up and yields down and now owns 30% of all outstanding issues. If your glass is half empty, you might see that as a threatening overhang. There again you could argue that domestic investment institutions must surely be underweight in gilts – and if I am right and the APF will sit on its holdings rather than sell them then I don’t see where the further downward pressure on gilt prices comes from.

As the government keeps loading future obligations onto taxpayers of the future, I fear that locking into a 2.5% return has a depressingly decent chance of turning out to be an attractive deal.

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