Sunday, 11 November 2012

The QE Conundrum

Source
QE - or 'quantitative easing' - is a once-in-a-generation financial phenomenon: there is no remotely similar parallel to refer to in order to understand the potential consequences.

It started out as a bold (some would say 'last ditch') attempt to generate growth in the UK economy. And now, with sleight-of-hand accounting the Bank of England is transferring the income it has earned from QE back to the Treasury.

But how will it end? And what should DIY Income Investors do about it? Here's my best guess...

The QE story so far:
  • As was normal, the UK Government sold debt (in the form of 'gilts') to private investors to finance its activities (via the Debt Management Office)
  • To stimulate the economy, the BoE (owned by the Treasury Solicitor on behalf of the Government) began in March 2009 to buy up a total of about one-third of  Government debt in a process called QE (the BoE calls it the Asset Purchase Facility),  - this process has now been capped at £375bn
  • This process effectively added £375bn to the nation's money supply
  • The Government pays a coupon on the gilts, and a proportion of these payments have accrued to the BoE: the BoE is now returning this money to the Treasury

On top of QE the Debt Management Office holds about £50 bn in gilts at any one time (during the financial crisis this was up to nearly £200 bn). They hold it because gilts are used as a monetary tool to control the the rate at which banks pay or get rewarded for holding reserves matches the target interest rate set by the Monetary Policy Committee (MPC).

The purpose of QE was to inject cash into financial institutions to encourage them to lend money to businesses to stimulate economic activity. To quote the BoE:

"The Bank of England electronically creates new money and uses it to purchase gilts from private investors such as pension funds and insurance companies. These investors typically do not want to hold on to this money, because it yields a low return. So they tend to use it to purchase other assets, such as corporate bonds and shares. That lowers longer-term borrowing costs and encourages the issuance of new equities and bonds."

As QE concentrated on shorter-dated gilts (the first mature in March 2013), this increased 'demand' pushed up the prices of these gilts - and, because the yields/prices of all gilts are related, pushed up prices on all gilts (including 'perpetuals', such as Consols, which I sold at an unexpected profit).

And the Government Debt?

Coming now to the state of the Government's finances:
  • The Government deficit is the amount that needs to be borrowed each year as the shortfall between  receipts (mainly tax) and expenditure: this is currently £150bn
  • The Government debt is the total amount owed (i.e. the total of gilts issued): this is currently around £1 trillion

Debt can only be reduced once the deficit is replaced by a surplus, or reduced as a proportion of GDP, by growth expanding faster than debt. However with a deficit of over 8%, the latter isn't going to happen, despite the rhetoric that growth is the only solution.

The price of Government debt is set by interest rate required to sell the gilts, which in turn is a function of the risk rating of the debt. For the UK Government, this is still AAA, but if this is downgraded, this would result in higher debt costs and an even harder job in reducing the deficit.

What Happens Now?

The overall out-turn on QE will depend on the price that the BoE gets for the gilts when they are sold. The interest payments were being set aside by the BoE to cover any losses the BoE might make on the eventual receipts from sales (or maturity payments). But as the Treasury has undertaken to reimburse any capital losses, this cash has now been transferred. And as it doesn't look like the BoE will be in a position to start selling gilts any time soon.

Many of the gilts bought by the BoE were trading above par, so if the BoE holds them until maturity, it will make a capital loss. When the gilts mature, the par value will be repaid by the DMO, which in turn will have to issue new gilts to pay for it. But when the market returns to 'normal' the DMO will probably have to borrow at much higher interest rates than it does today.

Gilt price prices are currently at a 250-year high: effectively a gilt bubble. When this bubble bursts, the BoE will be register a significant loss, that the Treasury will have to meet - through increased debt.

And this rapid growth in money supply may well be more inflationary than it currently seems.

It is difficult to see how all of these difficulties will be dealt with successfully. So, there will be a price to pay after all - but the bill will become dues onlyafter 2015, by a new Government - probably some new Lib/Lab or Lib/Con coalition.

What to Do?

The fall in yields in gilts has encouraged investors to look to other fixed-income sources, such as corporate bonds and blue-chip dividend shares: their prices have also increased (and their yields have fallen). Financial markets are all connected and DIY Income Investors should be looking at a big capital gain this year (my own portfolio is showing something like a 20% capital gain).

However, is difficult to see how this will work out well for investors in the medium term. The gainers from this policy were the owners of assets, whose price has been pushed up and who have sold them at a profit. The price of most income-generating assets is likely to fall: yields will then rise

What is more, either the economy with recover, and inflation will reappear, or the economy will remain stagnant and the UK Governments risk rating will be downgraded as it struggles to makes ends meet. None of this will be good for Sterling.

The most likely successful strategy for the DIY Income Investor will be to gradually realise capital gains now by selling and hold more cash, in order to repurchase the assets later more cheaply. But this is easier said than done, as holding cash in an ISA or a SIPP is not usually well rewarded.


I am not a financial adviser and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

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