Who Benefits from QE?

A report out overnight from the Bundesbank examines the impact of quantitative easing on the rate of interest German authorities pay to borrow money.

In 2007 the average rate for the government or a local authority to borrow was 4%, last year it was less than 2%. Over that period German authorities have “saved” €240bn in interest payments. Put it another way, that is €240bn of income investors have LOST out on as a result.

Bond prices globally have moved to ridiculously high levels as central banks manipulate the market and hoover up assets. Investors in all asset classes have traded lost long term income for short term capital gain. Unfortunately the history of most markets is that prices and yields normally move back toward longer term averages. As that happens who bears the losses? Well, not the government – it has locked in decade long low rates. Which leaves investors.

I’m a dyed in the wool capitalist, I believe passionately in regulated, free markets. I believe the system works best when the balance of risk and reward between borrowers and lenders is evenly spread. From 2001 to 2007 the balance tipped too far in favour of borrowers and we ended up with the global financial crisis as everyone “levered up”. We then spent 5 years trying to fix things with more regulation and capital controls. But since around 2012 we reverted to type. Hiding behind a smokescreen of “dis-inflation” (largely due to oversupply of commodities, where production was boosted by all the free money!) Central Banks continued to manipulate markets, boost asset prices and destroy long term value for investors by holding savings rates way below the rate of growth of G7 economies. Let us be clear – that boosted asset prices principally because borrowers had never had it so good. It disincentivised investment and innovation. It killed productivity. There is NO mystery behind that.

So if you intend buying an equity or a bond fund have a think about that. The German government has already made €240bn from your generosity. If and when prices reverse it is not they who will bear the losses.

A decade ago all the talk was of “debt socialisation” as the only means to get us out of the leveraged hole the financial and government sectors were in. Well, we need to WAKE UP people. Socialisation has happened. And if you are the one left holding the assets when the market turns, who is going to bail you out?

Sign up to receive our weekly BondTalk email

Not just all talk, maybe some trousers?

Well now, a month ago I wrote a piece comparing the current mania for buying government debt to “The Emperor’s New Clothes”. Let’s all lend to the government for returns massively below the level of inflation and growth and pretend it’s all good. Individually we all know the guy is in the nude, collectively we just ignore the fact.

Within a matter of days, a series of emperors – central bankers globally – rushed to point out they were indeed naked! In itself not a pretty thought. Ridiculously overvalued bond markets did what ridiculously overvalued assets have done for 500 years – they fell in price. And with the merest whiff of QE removal in the air even that decade-long bastion of stability, the global equity market, had a little wobble too (short lived of course).

The reaction to a potential 180 degree turn from the ECB, Bank of England, Bank of Canada and (whisper it) Bank of Japan has unfortunately been all too predictable. Sellers of risk peddled the line that Yellen, Carney et al now recognise how STRONG the global economy is, that they would not DARE raise rates unless the recovery was self-sustaining. So, go out and buy that risk because the market is only going in one direction.

We do need to remember that risk valuations are often based on discount rates – in short, the lower the level of government bond yields, the easier it is for equities to look “cheap”. And of course the lower the cost of borrowing, the easier it should be for companies to fund earnings growth. Mind you, things are clearly so good now that raising the cost of borrowing really wont matter will it? It’s not as if those same risk managers have relied upon (and publicly thanked) central bankers for their decade-long largesse.

But wait, perhaps the party is not yet over. Since setting up the market with a coordinated “we are going to raise rates” message, ECB, Fed and BoE officials have been back peddling faster than a Tour de France cyclist going downhill in reverse gear.

Today at 3pm is the first test, the first time we will see whether the rhetoric is matched by reality. The Bank of Canada is widely expected to raise rates. It kicked things off a fortnight ago telling us how rates needed to go up. If it does raise, then this may signal co-ordinated deeds as well as words to further remove emergency monetary policy globally. If so, judging by historic standards we probably have three to six months of risk assets doing okay. After that – good luck.

Of course, no rates increase and the party can trundle on a bit longer – albeit with an Emperor no longer naked but wearing a very small pair of pants.

Sign up to receive our weekly BondTalk email

More HC Andersen: The Emperor’s New Clothes

2017 is the 180th anniversary of the publication of Hans Christian Andersen’s short story “The Emperor’s New Clothes”. For those not familiar with the tale, it is the story of how two conmen convinced an Emperor to part with money for nothing – by creating a scheme whereby those who challenged prevailing wisdom were made to seem stupid. Ultimately the scheme unravelled when an innocent, a small child, laughed at the stupidity of the situation.

My problem – I’ve borrowed a bit of money and can’t really afford to repay it, so in a giant Ponzi scheme that would make Bernie Madoff blush I’m going to get people to give me more at ridiculously low levels, such low rates of interest in fact I really don’t need to worry about how much money I get.

My clever scheme – the economy is in a mess and I can sell you something that is guaranteed to make you a tiny amount of money. I know the data suggests things are actually as good as they have been for 20 years, but we all know “experts” and “facts” are so 20th century. Trust me, I can make you rich.

German 10-year bonds yield 0.25%.
German (nominal) growth is around 3.5%.
You can lend money to Germany and get 0.25% back each year.
Germany makes 3.5%.
Do that for 10 years: you get around 3% total return, Germany over 40% (did someone mention compounding?).

Now replace Germany with the UK, US (to a lesser extent) and even Japan.
But are Mark, Janet and Mario the Emperors, the conmen or the children?

Hey, if you want to buy the beta of the bond market – if you want that return-free risk – go ahead. Who am I to stop you?

One final thing to note: 2017 is the 176th anniversary of the publication of Charles Mackay’s seminal work – “Popular Delusions and the Madness of Crowds”.

The Ugly Duckling by HC Andersen, as translated by DAJ Roberts

Once upon a time there was a little red duck called Jeremy. He was shunned by the other ducklings on the pond who were a nice shade of light red, almost pink, unlike the strong scarlet of Jeremy’s plumage. But it wasn’t just the colour. The other ducklings – Tony, David, Ed and even that nice little Gordon – just couldn’t quite understand him; perhaps it was the accent, or perhaps the product of a poor education system? At times he seemed to be speaking a language foreign to theirs!

One day after years of teasing Jeremy, the gang woke up and found that he had grown into a rather attractive swan! They looked in astonishment at Jeremy swimming serenely along. And not only was he calm above the water, he no longer seemed to need to paddle furiously beneath the surface either.

But suddenly – to the amazement of all in view – up from behind the bushes (where she had been sharing a moment of quiet contemplation with her bestie Phil) leapt farmer Liz.

Without a moment’s hesitation she emptied both barrels of her shotgun (always kept loaded; oh how she longed for those days when foxes were fair game) straight into poor Jeremy. Red feathers everywhere.

“What the deuce did you do that for old gel?” asked Phil.

“Well” replied Liz, “My swans are supposed to be white. I saw a black one once – a portent of doom – and did nothing about it.”

“What happened?” Phil quizzed.

“There was a terrible storm about ten years ago. My house nearly fell down (in truth I couldn’t afford the mortgage but the nice man at the bank, Mervyn or Eddie I can’t remember which one, had told me not to worry about it) and half my money was washed away in the flood.”

With that, Liz turned on her heel and walked quickly back to her modest country abode. At her heels was her ever-faithful dog, Theresa, with a smile on her face (if indeed Corgis could smile).

Little did Theresa know that Liz had long had a hankering for something bigger, perhaps with a shaggier coat. Indeed, that very morning she’d been to the pet shop in Windsor and had started to look kindly on a golden Labrador answering to the name of Boris. He’d been a bit noisy, but in truth Liz worried his bark was worse than his bite. Still, if she ever needed a guard dog to ward off any more red swans, surely to goodness he’d be more use than Theresa?

And another thing Mr Carney…

A quiet weekend for me – my usual taxi-driving services not required. My 17-year-old son took himself off round a series of Universities, ostensibly checking them out ahead of deciding where to study next year. I note the perfect correlation between institutions on his list and places where he already has friends or relatives studying. No mug he – a week of free accommodation leaving the entertainment kitty fully stocked. I say ostensibly, for he long ago was offered and accepted a place for next year.

Having had time for reflection then, I remain irked by comments from the Bank of England and its Governor. Reading through the statement in detail, I share the incredulity of former MPC member Andrew Sentance at the focus on downside risks to the economy and indeed the apparent failure of the committee to model for all but the most benign Brexit scenarios. As a result the market is assuming no rate hikes until 2019 IRRESPECTIVE of economics. Paraphrasing the Pythons: other than inflation above target, growth around trend, a near 20% fall in the exchange rate boosting exports and tax receipts, stock prices at record highs, booming trading partners, record low unemployment, and an embargo on foreign workers likely to jack up average earnings, what have Brexit and record low interest rates done for us? Oh that’s right: renewed concerns at consumer indebtedness and a return to record house prices. And the Bank, along with most central banks, now admits to being worried at the level of consumer debt. A strange response this! ‘We are worried consumers are borrowing too much money, perhaps raising rates a little might curb that trend, but goodness me that might lead to a reduction in consumption and some defaults’. Now, when did I last hear that? 2008 I think. And that ended well…

Do you buy an alcoholic a bottle of whisky today so that he can avoid a hangover tomorrow, in the knowledge he’s more likely to contract cirrhosis in a couple of years’ time?

Sell gilts: UK high street inflation shocker!

I have just wandered to my nearest Starbucks for the bargain that was its “tall, black, filter coffee”. As others have paid £4 for their daily dose of vanilla-spiced, grande, half-fat frozen frappuccino, that august American tax-paying institution has been charging me the princely sum of £1 for real coffee. Indeed, this was actually 38p cheaper than the equivalent in my employer’s “subsidised” canteen.

Well as of 7am this morning that all changed. £1.25! 25% overnight inflation. The Scot in me is still wrestling with the conundrum – is the 13p residual saving versus a short trip to my canteen worth the shoe leather?

I wonder if Mr Carney and the rest of the MPC take their coffee black and, had they visited Starbucks this morning, would their monetary policy decision yesterday have been the same?

Like many people I am confused; not necessarily at the MPC rates decision, more with the accompanying rhetoric. Apparently the main reason for not raising rates was because UK consumers would face a squeeze this year from the impact of higher inflation, all of which was attributed to a weaker sterling. Eh, you’ve lost me there chief – the MPC cut rates post BREXIT in part to push the currency LOWER so that the impact of a weaker sterling would OFFSET some of the uncertainties of leaving the EU. If Carney is really worried about the squeeze on household income, firstly in part this is a situation HE created and secondly, by RAISING rates he could help reverse it.

Let’s be honest here. Central banks globally have expanded their balance sheets to nearly $18trillion in the past decade. That’s greater than US GDP. They have created the mother of all asset bubbles across most financial asset classes and now are sh*t-scared of unwinding. That and the ongoing need to fund ever-larger government deficits means they seek ANY excuse to keep rates as low as possible for as long as possible. Meanwhile, financial assets move ever-higher, the day of reckoning pushed further into the future, but likely to be all the more painful when it does arrive. Then again Carney, Draghi and Yellen can continue to manipulate markets longer than I care to work for. Good luck timing your exit.

Heed the lessons of the past

“Markets are highly correlated with historically low volatility. Central bank activity has created a “goldilocks scenario” where investors treat bad news as good and good news as excellent. As a result of low cost of debt, markets have been propelled to record highs. Investment grade spreads are well below historic norms, high yield defaults seem remote and Emerging Markets appear immune to historic cyclical patterns. Equity investors talk about re-ratings and multiple expansion as discount rates seem set to remain low; for most, it is not about whether to take risk or not, rather about how much risk to take!”

I didn’t write that today. I wrote it in a note to clients in 2006. At the time I was being urged to add more risk across my portfolio range. I resisted until the bail out of Bear Stearns (if you are under 25 you probably won’t remember that), which gave all of us a green light, that the US authorities would stand behind their financial institutions. And then: Lehman.

But everything is rosy, we have had 10 years of rising prices in financial assets and in the US at least regulation is (for now) much tighter. What could possibly go wrong? The Fed and ECB will each fail to tighten for a while yet, surely?

Why not ask yourself, with rising inflation, decent growth and near full employment would a Fed Chair steeped in 2007 events REALLY allow the economy to run THAT hot?

Sometimes it is right to sell everything. Just as ALL assets have risen in value since the advent of QE, so too can they fall together. Especially as monetary policy tightens.

My key thought for the rest of 2017 – “Markets are highly correlated with historically low volatility……heed the lessons of the past.”

PS: S&P 500 topped out in 2007 at 1576. Currently 2368, a nice 50% ABOVE the global financial crisis. I am often told equities climb a wall of worry. That wall must be pretty high, because they’ve been climbing it almost without a break for eight years.