6th September 2012
It said that this was likely to lead to more quantitative easing (QE). This, of course, was welcomed by markets, but has the Bank of England now created a situation where – for many market participants – the risks of economic recovery are greater than the risks of continuing weakness?
Fears that the US government may not announce another round of quantitative easing have pushed gilt yields below those of US treasuries for the first time. It is a sign of the extent to which the assumption of QE is driving down bond yields and therefore the potential impact of a normalisation of monetary policy. There are an increasing number of market participants for whom the resumption of economic growth could be a significant problem.
According to estimates from Schroders, banks, institutional investors and other private investors will have to plough an extra $1.4 trillion into US Treasury bonds over the next five years, an increase of more than 50% on the past period. This creates a lot of market participants who would suffer if yields were to rise.
Schroders chief economist Keith Wade believes that people will continue to buy in spite of the risk of capital loss: "De-leveraging, demographics and a shortage of safe assets are already pushing institutions in this direction." However, he also believes that the scale of investment is likely to make investors baulk, resulting in upward pressure on bond yields over the medium term.
As the Bank of England pointed out, economic recovery still looks some way off. The reason for the lower yield on UK gilts is perversely, a reflection of the UK's relative weakness rather than its relative strength. The US may not be in perfect economic shape, but markets are starting to believe that it is not sufficiently bad to warrant additional quantitative easing. The UK, on the other hand, looks set to continue quantitative easing, which is depressing yields.
"A recent uptick in US economic data, particularly in the housing and labour markets, has compelled some investors to pare expectations that the US Federal Reserve will unveil a third round of quantitative easing, or QE3, next month.
"In contrast, the UK's economic output has contracted for three quarters in a row, spurring the Bank of England to announce earlier this summer another £50bn of quantitative easing through to November."
However, markets will begin to anticipate economic recovery some way ahead of an actual recovery. The holders of an asset paying 1.45% (the current yield on the 10 year gilt) will suffer in a climate where interest rates are – or are expected to be – 3-4%. The worst case scenario for gilt holders would be if inflation took off at the same time. As such, economic recovery and the resulting normalisation of interest rates holds greater risks for certain members of the UK population than ongoing economic weakness.
At a basic level, the largest holders of gilts will suffer most. As the latest statistics show, around a fifth of the gilt market is held by the Bank of England. Overseas holders make up around a third of the market, while pension funds and other institutional investors form another significant chunk. The low borrowing costs also flatter the government's debt repayment statistics, though this would, to some extent, be counter-balanced by the improvement in economic performance.
Wade suggests that a rise in yields may not necessarily be bad news. He says: "Rising yields and the return of the bond market vigilantes may ease policy gridlock and focus the minds of politicians on reducing the budget deficit."
However, there remain real risks of capital loss for those who have soaked up all of this issuance. These market participants are better off with a continuation of the current climate rather than a resumption of growth and therefore normal economic policy. The question is the extent to which these participants will sway policymakers, who may be forced to continue the status quo for longer than the prevailing economic climate may require. This would be the climate for another boom, but surely people's memories are not that short?
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