Wednesday, July 8, 2009
Doubts grow over quantitative easing
By David Oakley Published: July 8 2009 03:00 | Last updated: July 8 2009 03:00 Quantitative easing has been one of the main weapons in the armoury of central banks this year as they battle to head off deflation and pump money into the banking system. Nowhere has the programme been more aggressive than in the UK. In just 17 weeks, the Bank of England has bought £107bn of gilts. Today it will increase that figure by £3bn to £110bn - 17 per cent of the entire market in tradeable gilts. So rapidly is the Bank moving that there is a good chance it will extend the QE programme further tomorrow, perhaps increasing the size of the programme to £150bn from £125bn. Inevitably, there are questions about how well QE is working. Government bond yields have remained stubbornly stuck around the same levels as the day QE was launched on March 5. Ten-year gilt yields are currently 3.67 per cent compared with 3.64 per cent just before the QE announcement. However, analysts say yields have risen because of hopes of economic recovery and worries about the vast amount of debt issuance rather than the failure of QE. They estimate that yields would be 50 basis points higher without the programme. Then there are questions about the extent to which QE is distorting the market. This is because the size of the Bank's holdings has reduced liquidity, which in turn has increased volatility - two things gilts investors hate due to the greater risk of getting on the wrong side of a trade. The Bank intends to hold these gilts for the time being but is expected to sell them eventually, once the economy improves. Scott Thiel, head of European fixed income at BlackRock, says: "The Bank of England's buying programme has brought some idiosyncrasies into the gilts market. The Bank has bought so many gilts that it has made some bonds very illiquid." The Bank alarmed investors recently when it prompted a panicky sell-off of two bonds - a benchmark five-year maturing in 2014 and an off-the-run issue maturing in 2021 - by announcing it would no longer buy them because it owned too much of the stock, more than 60 per cent in each. Yields on both of these bonds rose more than 20 basis points immediately afterwards. Mr Thiel says: "The Bank took the market by surprise when it said it was no longer buying the 2014s and the 2021s. This type of unexpected move could deter some investors from buying gilts, particularly overseas investors who might decide to buy other government bonds that do not have such a big buyer distorting the market." The unpredictability has turned attention on the Bank's decision to skew its buy-back programme so heavily towards gilts. The aim of QE is to increase the money supply, boost lending and bring down yields on corporate debt as well as government debt. The Bank could influence corporate yields by buying corporate debt directly. But it has bought just £1.9bn in short-term sterling commercial paper, or 3 per cent of outstanding issuance, and only £800m of sterling corporate bonds, or a paltry 0.45 per cent of outstanding issuance, says Dealogic. The Bank has decided against buying any asset-backed securities or syndicated loans, which are included in its asset purchase programme. This is in contrast to the US Federal Reserve, which has bought $197.7bn of US Treasuries, or 3 per cent of the stock, $621.6bn in mortgage backed securities and $96.8bn in agency debt. The European Central Bank has targeted the short-term money markets, which it has flooded with liquidity and covered bonds, with plans to buy €60bn in these securities to boost demand and activity. Ben Broadbent, UK economist at Goldman Sachs, says: "It's surprising not to have seen the Bank buy more private sector assets. The Bank has argued that some ABS [asset-backed securities] are cheap, relative to fundamental value." Some analysts are convinced that Gordon Brown, the UK prime minister, and the Treasury would like to see the Bank buy more private sector assets. However, any pressure from the government to buy these securities is likely to fall on deaf ears at the Bank, they say. One senior gilts strategist says: "I don't think Mervyn King [the Bank's governor] wants to pollute his balance sheet, particularly by taking on any asset-backed securities. "The Bank sees gilts as the best way forward for QE and will stick to buying government bonds." Gary Jenkins, head of fixed income research at Evolution, agrees. "What would the Bank be achieving if it bought corporate assets?" he asks. "The Bank's buying of gilts has reduced liquidity in the government bond markets, but if it bought corporate bonds, that could lead to liquidity drying up altogether in those markets as they are very illiquid." Most analysts think the Bank should step up its QE programme by buying more gilts as they fear deflation more than inflation, which can be tackled more easily with a raising of rates. Many expect the Bank to increase its buy-back programme by £25bn at either its rate setting meeting tomorrow or next month. John Wraith, head of sterling rates product development at RBC Capital Markets, says: "I don't think we are at the stage where the Bank has too many government bonds on its books. It has the scope to buy up to around £200bn if necessary. "The market is big enough and liquid enough to cope, and ways can be found to address distortions. If QE is going to work, buying gilts is the best course of action as it is the only market that offers sufficient depth and liquidity."