- New Science in old markets -

The longer-term consequences of QE

When we write, we write about feedback.  All our work stems from studying it - Extensions occur when positive feedback produces a self-reinforcing price trend that then goes ‘too far’ so it ‘extends’. Compressions happen when negative feedback causes self-limiting market behaviour that persists too long and must then burst into life. Turns come from repeated interaction between cycles which breeds more cycles. These three are not the only areas where we study interactive feedback, as new examples also spring up from time to time if some major change occurs in a previously stable arrangement.

The creation of the Euro abolished old adjustment mechanisms that had helped different economies get along together - what the UK Treasury might call ‘automatic stabilisers’ – with falling exchange and interest rates when performance was bad and the opposite when performance was good. Such adjustment mechanisms achieve their compensation through negative feedback but creating the Euro has now replaced this by the opposite kind - a positive (trend reinforcing) feedback in which success is rewarded and failure is punished. This is why German assets have risen in price for five years compared with similar Italian and Spanish assets, which have fallen. This does not make Mediterranean assets ‘cheap’ as the pressure pushing them lower is a constant presence and the German rise will only end with a bubble that will  eventually burst. We have written often on this and will continue to do so. If you don’t include feedback in your thinking it would be easy to adopt the wrong view - buying Spanish assets for example, because they seem ‘cheap’ or getting out of Germany because it is ‘too high’.

In the meantime other feedback loops are developing. We watch for them all the time but only write when we think they are taking effect. We made an exception by pointed out a potentially large one that has yet to grip the markets - that caused by Saudi Arabia’s financial position and its effect on oil production. This large oil producer is no longer a ‘low absorber’ of the oil income that it generates and its increasingly lavish expenditure means that it now needs that money. If and when oil prices next fall for more than a few weeks, Saudi Arabia will need to keep pumping instead of reducing production to nudge the price back up as it has done many times before. The negative, price-limiting feedback produced by Saudi Arabia acting as ‘swing producer’ will be replaced by the positive feedback effect of continued selling into a weak market. Other OPEC members will naturally follow suit and the consequences will be a very low oil price, for a while at least.

There is another feedback effect in financial markets which is caused by QE, as we have recently written. This does not involve repeated interaction so much as a serial ‘chain reaction’ - a one-off event in which a single trend gets amplified by its own consequences in what might be called a ‘knock-on’ effect. This is caused by the presence of central banks as large and relentless buyers in the debt capital markets, which not only distorts normal market operations but sets the scene for greater disruption later. The topic is poorly understood and so squarely in the domain of economists that the debate about its consequences has been almost entirely in the jargon of their trade. There have been a few comments from educated laymen but these have been restricted to observing effects as they arise, such as the destruction that QE is already wreaking on pension funding, rather than trying to foresee consequences before they happen. We will attempt to predict.

We are not economists and look at this from the financial markets viewpoint, seen through our feedback spectacles. QE in the US and UK adds money to the economy of each country through large-scale purchases of existing debt instruments, with the additional  intended effect of pushing down bond yields. These consequences are meant to stimulate economic activity and there is some evidence that they have helped, even though the results are modest compared with the scale of the operation. 

The European Central Bank’s (ECB) program of bond buying called Outright Monetary Transactions (OMT) has only the latter of these aims - to depress bond yields to make it easier for the Eurozone countries of the Mediterranean to keep selling new bonds at affordable rates. The ECB is worried about creating excessive money this way so is trying to ‘sterilise’ its purchases in the money markets, although this term is probably misleading. 

No matter what the motive, in each case this program of buying is a process similar to the normal open market operations of any central bank using ‘repos’ and ‘reverse repos’ – the purchase (and simultaneous forward resale) of bonds to add liquidity to the system, or the reverse operation to drain it. The main differences are the sheer scale of the QE/OMT operation and the absence of the forward resale part. Central bankers always like the idea of applying a gentle pressure to markets, so doubtless it is the process that is important in their minds. It has gone on long enough (in the case of QE) that there are two unintended consequences that come from the large cumulative amount of paper that has been bought:

First the removal of such a large quantity of bonds from the market reduces the ‘float’ of those bonds that are easily tradable. This is one of the reasons that government bond markets are usually so liquid and any further purchases in these newly illiquid markets will result in much sharper upward movements in price.  This makes it very easy for the process to ‘overshoot’ on the way up. Conversely, ending the purchase program will lead to a sharp drop in prices, whenever that may happen.

Second, this is similar to a market ‘corner’, a manoeuvre occasionally attempted by over-funded but ignorant market manipulators. This consists of buying all the available amount of some targeted market, forcing shorts to cover and pushing the price up far beyond any ‘fair value’. At that point there is a large paper profit on the amount that has been bought and the perpetrators of the corner feel smugly happy. Trying to take that profit by selling their large holdings then pushes prices far below their entry cost and so the inevitable result is a substantial loss.

The most famous corner was the Hunt brothers’ attempt (with help from some Lebanese bullion dealers) to corner Silver in 1979/80 which reduced them from billionaire status to penury. There has been a more recent try in the cocoa market that is still being unwound. Corners always fail in that they cause the instigators to lose far more money than they started with and the same will doubtless be true of this situation in government bond markets, even though the intent has been benign. Market manipulation by extreme purchases will have the same consequence whatever the reasons may be for embarking on it and no matter how apparently sound the finances of the protagonists may be. The Bank of England has been overwhelmed before, after all and there is nothing sacred about the US Treasury either. Their probable insolvency is a grim prospect and it seems likely that some accounting trick would be invented to allow central banks to avoid valuing their bonds at market prices if and when values eventually plummet. That would merely postpone the reckoning of course, as the world financial system could not rely on institutionalised dishonesty.

This may be the world’s first unintentional ‘corner’, is certainly the biggest and the negative results will be commensurate with the scale. QE was originally an inventive solution to a short-term problem that arose when the financial system trembled in 2008/9. It then became the only weapon and has now been used for so long that central bank holdings of bonds are dangerously large.

This could play out in several ways but here is one possibility: Some renewed economic weakness in the near future provokes yet more Bank of England buying of paper, pushing the total of purchases over one third of total GDP - the amount bought is already £375bn and reports from the Bank’s monetary committee suggest another £175bn may be ‘needed’. Remember that no other weapon exists and yet economic growth is almost completely absent, so more QE is likely. UK annual GDP is around£1,500bn. 

Prices of UK government bonds (Gilts) then shoot up to new highs, provoking more buying from the marketplace as ‘momentum’ takes over. Economic activity shrinks as businesses take fright because the signal is read as ‘the economy is worse than you know’. Banks stop lending again, especially to one another and the capital markets for corporate financing dry up - the only bonds that can find buyers are government bonds at the regular auctions. The tax base duly shrinks and credit agencies reduce UK rating to below investment grade. No-one then buys government bonds, hoarding cash and ‘hard’ assets instead. Bonds fall and fall more. The Bank creates yet more money so people lose faith in cash too and start a housing bubble. A hostile foreign government demands that the Bank of England repay what it owes and the Bank is revealed to be insolvent, due to its huge holdings of gilts that have plunged in value. The printing of money increases again and runaway inflation suddenly starts. The insolvency of the BoE contaminates other central banks that also give in to inflationary solutions. Revolutions start, followed by military coups. All this because, in the words of Herman van Rompuy, the President of the European Council as he revealed the cowardice of politicians in the face of spiralling government debt: “We all know what should be done but none of us can see how to get re-elected after doing it.”

Meanwhile, Europe’s politicians congratulate themselves on holding the Eurozone together.  Few note that preserving it further will need a lot more bond buying from the ECB as the next crisis looms in the Southern countries, so storing up yet more trouble for the near future. The Eurozone may have navigated some rapids in the river but there are waterfalls ahead. As there are for the UK and the US.