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Cowley: QE is not working - gilts are effectively worthless

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Cowley: QE is not working - gilts are effectively worthless

The Bank of England is running out of options on what to do next.

The current Quantitative Easing (QE) program is fast approaching its end. The Bank now owns some £275 billion of gilts, which is close to 30% of the total market. This is a staggering amount and one that is not widely acknowledged and for which there has been little or no public debate.

What’s more, the effectiveness of the policy has to be questioned. The Bank implements QE through the so-called ‘portfolio channel’, whereby it buys gilts not from the government but from banks and pension funds and the like. The idea is that the cash is then sent into the economy…somehow.

No signs QE is working

But on any measure, there is precious little evidence that it is working.

For instance, lending to consumers fell £377 million in December. Even worse, year-on-year borrowing by consumers has taken a lurch back down, even from the low levels it had achieved in 2010/2011, which in itself was a fifth of the peak in 2004.

So whatever QE was meant to achieve, all it has really done is transfer a large amount of capital risk (duration) out of the hands of the private sector and into the hands of the state, through the agency of the Bank.

As we have pointed out in the past, there is some doubt as to how much more effect QE can possibly have when government bond yields fall below 2.5% – 3.0%. Amazingly, this is exactly where long-term gilt yields have gotten to recently.

Gilts are effectively worthless

At the same time, on a number of valuation metrics (against inflation or credit default costs for instance), gilts are effectively worthless as an investment, unless your primary concern is to hide your money away from a banking system that will be prone to shocks for some time to come, especially if there are further episodes of uncertainty coming out of Europe.

This shouldn’t be underestimated as a possible use for gilts in the future (you could liken them to a safety deposit box) as many sage commentators, like George Soros, are currently lining up to call the end of the euro in the years to come. Clearly, there is trouble ahead.

What to do next is matter of urgency

£275 billion is the maximum amount so far made available for QE so the Bank needs to consider urgently what to do next.

It is a vexed question. Interestingly, literally as we write, Adam Posen of the Bank’s monetary policy committee is suggesting in an interview on Bloomberg that, 'It would not be the end of the world were the MPC, as part of its monetary policy efforts, to buy things other than gilts.' This is as much as an admission of failure.

The rumpus over RBS boss Stephen Hester and his bonus (augmented by the disgracing of Fred Goodwin and the removal of his knighthood) has only served to highlight, once more, the problems that have come with the Labour government’s equity investment in the Lloyds Banking Group and Royal Bank of Scotland.

Although there have been three occasions when the share purchases have been in profit, things took a turn for the worse in 2011 and now the UK public is around £13bn offside on the investment.

The government bought shares in Lloyds and RBS with the aim of stabilising the UK financial system, but the loss on the investment highlights the risks.

The US Federal Reserve has bought equities in the past, but buying and selling shares is not a skill-set that is known to be highly developed at the Bank and it is not a realistic option for the next phase of QE – especially when the capital (duration) risks already inside the Bank are already so tangible.

Lifting loans out of the banks may be a way forward which would be to ape the recent program of the European Central Bank to a certain degree. The policy would become: ‘Give us your rubbishy bank loans and we will exchange them for crisp new pounds so that you can go and help the economy’. This must be a tempting thought given the dire state of UK GDP and the prospect of years of government spending restraint to come.

Buy corporate bonds

Instead, the Bank might like to start buying something that would actually help the economy and on which they stand a fighting chance of making a profit – corporate bonds. If QE is really about reducing the cost of capital for private enterprise then there would be no better way of supporting the economy at this time.

Simultaneously, the relatively illiquid corporate bond market would be easier to manipulate and a lot less money would have to be thrown at it to get substantial results.

A further QE program of £50 billion - £75 billion in the corporate bond markets would have a substantially bigger effect than all of the gilt purchases put together.

The problem for the Bank is that they need to get money into the hands of companies which are close to the real economy, companies that will buy UK goods and services and employ UK voters. Not big corporates like Shell or BP, but the type of company typically issuing bonds in the BBB—B area of the credit rating spectrum.

Politically a corporate bond QE program would be a winner as it would help stimulate the rise of the private sector which would, in turn, begin to absorb the jobs lost in the public sector, as has been promised by the Conservative/Liberal Coalition government.

The flip side to this prospect is that any hint that this is about to occur would be bad for gilts – yields would rise from the current artificially depressed levels.

But with corporate bond yields still at elevated levels a corporate bond/loan QE program would carry with it a possible by-product; that the Bank could actually make a profit from the next phase of QE.

Having transferred a huge amount duration risk into our central bank the next phase could well be the biggest transfer of credit risk out of the hands of the private sector and into the state that this country has ever seen. So if any of you thought there was light at the end of the QE policy tunnel think again. It’s not a light, it’s the next train coming…

Stewart Cowleyis manager of the Old Mutual Global Strategic Bond fund. According to Lipper, in the three years to 6 February the fund has returned 43.2% versus a 13.75% rise in the benchmark.

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