On the QT

2009 saw the world embark on a giant economic experiment – that of Quantitative Easing (QE) in which Central Banks injected large amounts of money into their financial systems. Next month, the Federal Reserve announced this week, will see a new first for monetary policy – a policy of Quantitative Tightening (QT) in which money will be withdrawn from the financial system.
They have announced that this new policy will be phased in, starting at a rate of $10bn per month from October, rising each quarter to $50bn per month by October 2018. At the same time, they expect to raise interest rate four more times to 2% by the end of 2018.
The timing of this policy shift appears less related to current economic conditions and much more to two other factors. First is that Western Central Banks appear, as a group, to have decided that the very easy monetary policies need to be pulled back. In addition to the Federal Reserve, the Bank of England has also recently indicated its desire to increase interest rates and the ECB is has laid out plans to bring to an end its QE programme. This tightening seems to be globally co-ordinated. Secondly, the Federal Reserve appears to be publicly setting out its policy for the next year, in such a way that it would be embarrassing not to carry it through. This comes at exactly the time that there are many places on the Federal Reserve Board to be filled over the next twelve months by nominees of President Trump, including the key role of Chairman currently filled by Janet Yellen.
Over the period of QE, from October 2008 to October 2014, the Federal Reserve increased its balance sheet from about $750bn to $4.5 trillion through 3 separate programmes of purchases. Its peak purchase rate was $85bn per month.
The widely accepted effects of the QE policy were:
1. It helped to offset the effects of the Global Financial Crisis in 2008/9, and prevented a 1930s style Depression from setting in.
2. It has done little to foster a rapid economic recovery, instead US GDP growth has stabilised at a muted 2% pa rate, only a little higher than the increase in population, and inflation has struggled to exceed 2%. There is little evidence that the increased money supply has found its way into the real economy through physical investment.
3. The prices of financial have moved much higher, principally through higher valuations relative to the income streams they produce. This is evident in house prices, stock prices, bond prices and the prices of prestige assets such as artwork and vintage cars. The increased money supply has thus remained within the financial economy rather than the real economy.
4. The combination of lacklustre real economic growth, rapid growth in financial asset prices, and the skewed distribution of wealth in the US economy has meant that the very wealthiest in 2008 have become even more wealthy and inequality has risen very substantially with the richest 0.1% gaining much more than the richest 1%, who gained much more than the richest 10% who gained much more than the rest of the population.
The implications of QT are thus that what has been to be a key support for financial market prices will be reversed by falling valuations as money is withdrawn from the financial system. It may also be that in fact this has a limited impact on the real economy as the decline in wealth will affect only the very wealthiest in society who demonstrate a low correlation between changes in their wealth and changes in their spending patterns.
A deeper concern is that QT will affect valuations in both equity and bond markets at the same time. Most investors have not seen an environment in which both markets fall simultaneously and this has the potential for aggressive selling of leveraged positions in markets, which could take markets down to surprisingly low levels.

2013 – Limited growth and new monetary policy regimes

As 2012 draws to a close, three things about central banks and monetary policy are becoming more apparent. Firstly, central bankers are concerned that they are being expected to fix all the ills in their economies and they believe monetary policy cannot achieve such ambitious targets.  Messrs Bernanke and King have both recently expressed concerns about the limits of what monetary policy can deliver in the face of fiscal austerity.  Secondly, successive doses of Quantitative Easing (“QE”) are generating diminishing impacts on markets and on the real economies.  This is a problem that the Bank of England has recently been highlighting about QE in the UK.  In the US, the recent, and fourth, QE announcement from the Federal Reserve, which will mean over $1 trillion of money printed every year until further notice, saw the US stock market fall on the day, in contrast to all previous QE announcements.  Thirdly, Central Banks are exploring new policy targets: in the US tying policy change to the unemployment rate; in Japan seeking to increase the inflation target; and in the UK discussing the idea of a nominal GDP target in place of an inflation target.   As 2013 begins, investors need to take into account the above developments in their investment strategy.

There are two distinct scenarios for 2013.  In the first, economic recovery and job creation continue to disappoint, in which case it appears increasingly likely that governments will tell Central Banks to concern themselves much less about inflation and more about unemployment.  If so, they would be doing this just as the Central Banks are coming to the conclusion that their current policies to boost growth, are not working very effectively.  The results would be monetary policies that are far more inflationary in intent than has so far been the case since the crisis – this would be a significant regime shift for monetary policy.

Investors therefore will need to seek greater protection from the risk of such a regime change.  This requires heavy weighting to assets that would do well in the face of a generalised increase in investor inflation expectations.  These assets would be index-linked bonds and gold.  The performance of company shares in a scenario of rising inflation expectations is mixed – over the long term company profits would be expected to rise with higher nominal growth, but in the shorter term, rising inflation tends to lead to lower valuations.  Conventional bonds would suffer very badly in an environment of higher inflation.  Commercial real estate would, in the very long term, be expected to act as a form of protection against inflation (as rents rise with inflation).  However, a combination of high unemployment and the shift towards virtual retailing is acting as a significant dampener on demand for office and retail space.  Short term prospects for returns are limited to current rental incomes alone.

In the second scenario, where the global economy does improve enough for unemployment to fall at a rate that was satisfactory to policy-makers, the response from financial markets would also be likely to be higher yields on conventional bonds, together with higher company share prices.  Given these two scenarios (of which the first, disappointing growth, is more likely ), the preferred investment strategy is to be at least neutrally invested in shares, heavily under-invested in conventional bonds and heavily-invested in the “insurance policies” of index-linked bonds and gold.

Returns on cash will remain very low in 2013 and in fact are likely to decline further if further monetary easing takes place – the aim of the Central Banks being to over-supply liquidity to the financial system.  Given the exceptionally low yields available on government bonds, it is difficult to imagine a scenario in which they deliver strong returns.  Corporate bonds, which performed very well in 2012 as credit risk perceptions declined, still offer higher yields than government bonds.  However, they no longer have the potential for significant gains from a further narrowing of the yield premium (over government bonds).  Other areas of the bond markets where the yields are still attractive relative to their risks, are emerging market local currency bonds and short duration, high yield bonds in the US.

The Eurozone economy, the UK’s largest trading partner, looks most likely to continue to disappoint next year, and so create problems for policymakers. Its key economic issue (and Mrs Merkel’s favourite trio of statistics) is that it boasts 7% of the world’s population, 25% of the world’s GDP but 50% of the world’s social spending.  This is at the same time as its demographic patterns are about to deteriorate significantly in the face of a very weak birth-rate and a rapidly expanding population of pensioners.  The sense of existential crisis about the euro may have passed for now, following the ECB’s promise to be prepared to act as purchaser of last resort for sovereign government bonds, but the danger for the euro in 2013 is more likely to come from the streets of Greece or Spain, as continued austerity bears down even harder on the public.  The Italian election is also likely to see a strong performance from anti-austerity parties.  The Eurozone enters 2013 in recession, and its financial system woefully undercapitalised.  For Eurozone markets to perform well in 2013, the ECB will need to be seen to be actually printing money – this is still an unlikely prospect, given the deeply conservative approach to monetary policy of many of the ECB members.

The Japanese economy starts 2013 with a newly-elected Prime Minister who campaigned on a promise to stimulate the economy aggressively and have a higher inflation target.  A weaker yen would be enormously helpful to Japanese industry regaining competitiveness, and after a 23 year long bear market, the stock market may finally be in a position to move higher.

The US economy, still by some distance the largest and most important to the world economy, should continue to grow modestly, but not at a rate that is likely to bring down unemployment sharply.  The short term is clouded by fears over the “fiscal cliff” negotiations, the results of which are likely to produce some modest austerity, which, if European experience is any guide, will cause some damage to growth prospects.  Expect a mediocre year for returns from US assets.

The Chinese economy, the single largest contributor to global growth, appears to be seeing a pick-up in its growth rate after the below-target 7.4% report for third quarter GDP growth.  Growth is unlikely to return to the double-digit growth rates seen in the last decade, but should be of higher quality for stock market purposes.  Instead of relying on exports of low-cost labour manufactured goods and state-sponsored investment spending, Chinese growth in the future is more likely to come from satisfying the increasingly demanding Chinese consumer.  China is also in the fortunate position of having considerable scope to ease monetary policy in conventional ways should its growth prospects deteriorate.  These more conventional methods are generally more effective in the face of weak demand, than the unconventional methods that Western Central Banks are currently forced to use.  Asian equity markets are once again expected to be the best-performing region of the world in 2013.

The UK economy remains buffeted by the trends from the European, US and, to a lesser extent, the Chinese economies. The government’s fiscal austerity programme bites a little harder in 2013 than it did in 2012, but the change in Governor at the Bank of England is likely to lead to a wider discussion about monetary policy means and objectives, which may support the UK bond and equity markets better than those of the Eurozone.  Expect a modest year for returns from UK assets and a weaker Sterling following its surprising strength in 2012.

In conclusion, global economic risks are, in our opinion, biased to the downside for 2013. If these risks are realised, the clamour for a policy response will be very great.  The shift from the 2008 conventional policy responses of lower interest rates and higher government spending to the less conventional 2009-2012 policies of QE may well then develop into a shift to very unconventional policies.  These have not to date been openly discussed, but could include such ideas as (i) using QE to buy shares rather than government or mortgage bonds, (ii) using QE to buy foreign government bonds (equivalent to deliberately pushing down the exchange rate), or (iii) pushing new money more directly into the real economy by for example printing money to pay a “citizen’s dividend” in the hope that it would be spent.  These are all theoretical ideas that would normally strike inflationary fear into the hearts of Central Bankers, but may appear next year as the logical next steps in monetary policy.


A layman’s guide to Quantitative Easing

Until very recently, Central Banks generally conducted their monetary policy through changing their key reference interest rate, which was generally the rate at which they would lend to the commercial banks on a short term basis supported by acceptable collateral. Thus the economy was regulated by changing the price of money. Theoretically, by increasing the rate of interest in the economy, the desire to borrow and spend would be reduced and the desire to save would be increased, and economic growth and inflation should fall back. Conversely, reducing interest rates should help to boost economic growth. It is generally accepted by monetary economists that the impact of changing interest rates takes between one and two years to have its full effects on the economy.

However in late 2008, the shock to the global economy from the financial crash that most Central Banks cut interest rates to the lowest practical levels (somewhere between zero and 1%, depending on the system), but still felt that they needed to ease policy further to offset the strong recessionary forces that were being experienced.

Thus, they turned from easing through changing the price of money in the economy to easing through changing the quantity of money in the economy (hence the rather ugly term “Quantitative Easing” (“QE”)). The Federal Reserve and the Bank of England began their QE programmes in April 2009, but in fact the Bank of Japan had been engaging in QE policies since 2003, its rates having reached zero in the previous global downturn.

Until this century, QE had only ever been seen as a theoretical tool in the Central Banker’s arsenal. It was a lesson that some (most notably Ben Bernanke) learned from the Great Depression, where once interest rates reached a low point, the Central Banks felt that there was nothing else they could do. There is thus no history or experience to examine to determine if it works or how it works. The current policy is therefore a live economic experiment.

The manner in which Central Banks have indicated they expect QE to work is as follows. The Central Bank goes into the financial markets and buys securities, typically government bonds, although the Federal Reserve has also bought mortgage-backed securities, and the Bank of Japan has also bought equities and REITs. To finance this they create the money (digitally) and use it to pay the seller of the security (typically a bank). The bank’s assets now consist of more cash and less securities. Typically the income return on the cash will be lower than the income return on the securities they have just sold, and so they have a decision to make. They could choose (i) to maintain the lower income stream, because they might have a great need for liquidity, (ii) to go back into the securities markets and buy some other securities to maintain their income, or (iii) increase their lending to companies or households. Choosing (i) has no impact on the real economy and choosing (iii) clearly has a major impact because it is helping directly to boost demand and spending in the economy.

In practice, what has happened is that banks have chosen (ii), and have sought to maintain their income stream by investing in higher-risk securities. Thus yields have fallen first on government bonds, then on investment-grade corporate bonds and finally on high-yield bonds. This then gives companies the opportunity to borrow at lower rates of interest in the financial markets, which could be used to fund investment. QE, to date, has been a policy that has clearly supported financial markets – it is difficult to see a direct effect on bank lending and economic growth, but it is likely (and claimed by the Central Banks) that economic growth would have been much weaker without QE.

There are some problems with continued applications of QE. Firstly, it is generally believed by economists that QE policies have less impact as they are repeated. Since it is such an unusual policy, the first time it is deployed it has a shock effect, but later iterations do not as the financial system adapts its behaviour to the policy. Secondly, the liquidity of the underlying financial markets may be damaged. For example, the Bank of England now owns more than one-third of all gilts outstanding, and has no current plans to sell them, so the level of liquidity in the gilt market has been reduced by the policy.

The great fear that many commentators have about QE is that by creating more and more money in the financial system without greater economic output, the end result must inevitably be higher prices. In fact higher expected inflation is one of the objectives of the policy, since if people expect higher prices in the future it is rational to buy things now before they rise in price, and so boost demand in the economy today. The response of the Central Bankers would be to say that QE is a reversible policy, and the bonds that they have purchased, can very easily be sold back into the financial markets, so reducing the excess liquidity in the system, and the inflationary threat.

To date, a more realistic concern has been that there is no evidence anywhere in the world where QE has worked. It clearly has not brought Japan out of its long term stagnation, and so far neither the US or UK economies can be said to have recovered strongly. The reason for this is that the extra liquidity generated has remained within the financial system and not found its way into the real economy, and so boosted real demand. If the underlying causes of weak economic growth are that the banking system has overlent relative to its capital, that consumers feel their debt levels are too high, and both feel that they need to retrench (or in the jargon, deleverage their balance sheets), then the current policy of QE will not actually affect the desire to borrow or to lend.

A more radical policy option would be to print money and ensure that it was only used in ways that directly benefitted the consumer’s balance sheet. Thus £450 billion (only a little more than the total QE to date) could be used to give every adult in the country £10,000 to be used either to repay debt, or towards a deposit for the purchase of a first home or into a pension pot. By improving the savings to debt ratio of each adult in the country, the time at which they will once again feel happy to spend more will be brought forward.

Bernanke sets the printing presses to “GO” and walks away

The recent decision of the Federal Reserve to go ahead with a policy of QE3 by which they buy $40bn of mortgage and agency securities every month until further notice was dramatic and shocking in many regards:

  • Timing – Historically the Fed has sought to avoid making major policy moves in their last meeting before an election for fear of being seen to be acting politically. In 2008, there was a global crisis which required action – this is not the case in 2012.
  • Politics – Romney and many in the Republican Party have already made clear their opposition to Bernanke personally and to the policies of Quantitative Easing already adopted. Were Romney to be elected, he might choose to ignore the fact that Bernanke has been appointed until 2014 and seek to get him replaced. The Fed’s action can be interpreted as a major political snub at a critical juncture.
  • Economic justification – Both QE1 and QE2 were introduced at a time of clear weakness in the US  economy and significant financial market concerns about the possibility of deflation. So far this year, the US economy has been growing at about a 2% rate, unemployment has been declining gently and inflation expectations have been rising.
  • Size – At $40bn per month, the policy amounts to an annualised rate of QE of  half a trillion dollars. However, the reinvestment of principals and coupons and the continued working of Operation Twist (which followed QE2) mean that for the rest of this year the Federal Reserve will in fact be purchasing securities at an annualised rate of over a trillion dollars. These are astonishing amounts of money.
  • Transmission mechanism – In the press conference following the decision, Bernanke was asked about how he expected this policy to have real world effects. He repeated his  belief that by raising equity prices, companies would find it cheaper to invest. In addition, he said that because this time the Fed was buying mortgage securities, this would reduce mortgage costs in the economy, thus boosting house prices, so helping consumers to feel wealthier, which would encourage them to spend more. This trickle-down effect of previous QE policies from injecting money into financial markets moving into the real economy is widely believed not to have worked. It appears to benefit those in financial institutions whilst having little real economic impact.
  • Duration – By making QE3 open-ended and further insisting that the Federal Reserve would not begin to tighten policy until recovery was very firmly established, even at the risk of some higher inflation in the short term, Bernanke has made it very clear that continuous easing is now the default policy setting, probably for several years. Previous QE announcements were for set amounts of money over set periods of time – this is very different – money will continue to be printed until the economy recovers.

So the unlimited money printing of the Federal Reserve now sits alongside the unlimited buying of peripheral bonds by the ECB announced the week before  and the unlimited selling of its currency by the Swiss National Bank that has been in operation for a year. Central Banks – so long famed for their moderation and control in all things relating to money have set the printing presses to “GO” and walked away.

One conclusion that could be taken from this is that the Central Banks, who we hope are a little better informed about these things than the rest of us, are terrified, and that the state of the global economy and financial system is in fact far worse than anyone is prepared to admit.

The clearest market implications of this shocking move are to expect a weaker dollar (with so many more dollars now being printed) and a higher gold price. QE1 and QE2 were positive for equity prices, but the biggest beneficiaries were precious metals (gold and silver), oil and agricultural commodities. It is by no means clear that QE3 will do anything to boost real growth in the economy, and so the boost to equities may be more short-lived and less significant than previous rounds. Most interesting has been the recent moves in government bond markets where yields have risen as long-term expected inflation worries have begun to return.

A layman’s guide to the LIBOR scandal

LIBOR stands for London InterBank Offered Rate. It has become the global benchmark for market interest rates – these are related to but different from the official interest rates set by Central Banks at their policy meetings, eg Bank of England Base Rate.

Each day at 11am, a group of banks (a different group for each of 10 currencies, generally those who are considered most active in each currency) submit to the British Bankers Association (via Reuters) the rate of interest at which they believe they could borrow from other banks over 15 different maturities ranging from 1 day to 1 year. For each currency and maturity, the BBA exclude the top quartile and the bottom quartile and calculate the average of the middle two quartiles. This average is then published as the daily LIBOR fixing. Over time this has become the benchmark used for market interest rates (similar to the FTSE 100 Index used as the market benchmark for UK stocks), and has thus become the reference for nearly all derivative contracts relating to interest rates and many other loan contracts. Estimates as to the total value of contracts outstanding in LIBOR-related contracts vary since much of the trading is carried out as transactions directly between banks and not on market exchanges, but $300 trillion (12 zeroes in a trillion) is probably a conservative estimate – equivalent to more than $40,000 for every human being on the planet. A change of 1 basis point (0.01%) for 1 day on that nominal exposure results in $120 million of cash flow difference moving around the global financial system.

Arguably there are 3 scandals (so far).

  • From 2005 to 2007 when light-touch regulation was in vogue and banks proprietary trading desks were making enormous profits with consequent internal political power, it has become apparent that traders at Barclays and other banks sought to influence the rates that were contributed to the BBA by the rate contributors both at their own bank and in at least one case in other banks too. They were doing this to suit their own trading positions (by trying to get LIBOR to be marginally higher or lower so that they would make greater trading profits)
  • During the 2008 crisis, when lending between banks broke down and the entire financial system came close to collapse, there were no actual trades on which to base the numbers that the banks sent into the BBA. Further many banks did not wish to disclose the weakness of their positions to the wider world and so told their contributors to bias downwards their expectations of what interest rate they would have to pay in the market should they have been able to.
  • In 2007 the New York Federal Reserve were sufficiently concerned by what they felt was a weak process for such an important market price, that they wrote to the Bank of England about their worries. Mervyn King and Paul Tucker appear to have done very little in response to this warning, a fact that has already been picked up by the Treasury Select Committee.

Of these three scandals, the first is criminal if true and can be proved. However the method of calculation is designed to throw out entirely the very high and the very low inputs – it would require an enormous conspiracy between many banks to actually alter a LIBOR rate. The third is a political loss of face for the Bank of England and King and Tucker in particular – it will probably cost Tucker the chance of succeeding King as BoE Governor. The second is almost certainly true but equally contributed to keeping the whole financial system alive – the world was so chaotic at that time and no actual interbank trades were taking place that every LIBOR rate input was a judgement without any evidence to support it. It will be difficult to prove in a Court of Law that a knowingly wrong number was submitted. It is entirely possible that had banks contributed less optimistic judgements of their ability to borrow at the time, then the higher LIBOR rates this would have created could have made the crisis worse

Note that the 2005-2007 scandal involved only dollar and euro interest rates but not sterling rates, so no sterling borrower or lender will have been damaged by it. However this scandal reinforces the long-running narrative of politicians that banks have become forces of evil and must be increasingly heavily regulated. Sackings and resignations of the interest rate traders and many of their superiors right up to CEO level have and will continue to occur. A new system for calculating market interest rates is likely to be brought in in due course, one that will be based on actual transactions rather than best guesses. In the meantime compliance departments will be scrutinising very carefully every input to the BBA.