Quantitative easing in the U.K.

Thirty years ago, it was “Anarchy in the U.K.” as Britain tried to get away from its role as the sick man of Europe. That meant civil unrest, high inflation and a weak economy. Margaret Thatcher was seen by many as the solution. Today, the British economy is sick again and there is anotherready solution to hand: quantitative easing a.k.a printing money:

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Thirty years ago, it was “Anarchy in the U.K.” as Britain tried to get away from its role as the sick man of Europe.  That meant civil unrest, high inflation and a weak economy. Margaret Thatcher was seen by many as the solution. Today, the British economy is sick again and there is anotherready solution to hand: quantitative easing a.k.a printing money:

Everyone knows a shiny new bridge when they see one. Quantitative easing, on the other hand, has been a mystery to all but hardened anoraks until zero interest rates started to loom late last year. Policymakers worldwide now pin their hopes on quantitative easing’s ability to complement traditional fiscal stimuli as a means of boosting demand. Even if they feel boosting money supply worth a try, few have a genuine conviction that it will work. There are three big problems with central banks buying unsterilised financial assets. The first is signalling. The normal process of tinkering with interest rates is based on eons of data on the effect on growth and inflation. That in turn provides a framework round which future rate moves can be forecast. Quantitative easing, however, is messy. That calls for clear targets. But based on what? Targeting particular measures of money supply, bank lending (as Japan did) or long-dated gilt yields is tricky.

Even with targets, the second problem is working out exactly how much quantitative easing is enough. Very simply, whether raising the money in circulation boosts incomes depends also on what economists call the “velocity” of money. If those selling assets to the central bank simply put their spoils on deposit, for example, the potential boost from the increase in money will be tempered. Knowing the velocity of money therefore is crucial. Yet this number is hard to pin down.

The final headache lies in selecting which assets to buy. As the Bank of England showed last week, most central banks go for government bonds. But these tend to be owned by financial institutions, not the ailing companies and households that need the money most. Besides, government bonds are already super liquid. It would be preferable for central banks to swap cash for harder-to-shift assets such as commercial paper. Another plus would be that purchases of such assets would remove their liquidity discount, giving the likes of the Bank at least a fighting chance of recovering their money when things finally recover enough to sell again.

So now we know that the U.K. is down with the printing money programme. So what? What will that mean to the average British citizen? Well, if the price action in today’s market is any judge it means two things clearly: a weak British pound and lower interest rates. First, there is Sterling:

The pound fell against the dollar and the euro as HSBC Holdings Plc, Europe’s largest bank, dropped to a 12-year low on concern over bad loans at its U.S. unit.

The British currency also weakened against the Japanese yen and the Swiss franc as HSBC declined as much as 14 percent, driving the FTSE 350 Banks Index as much as 10 percent lower. Lloyds Banking Group Plc said March 7 it would place 260 billion pounds ($367 billion) of assets into a state insurance program, capping losses and giving the government a stake that may rise to 75 percent.

“Banking stocks in the U.K. are under pressure today,” said Steven Barrow, head of G10 currency research at Standard Bank Plc in London. “That backdrop is negative for sterling.”

The pound fell to $1.3948 as of 9:16 a.m. in London, from $1.4094 yesterday. It weakened to 90.42 pence per euro, from 89.78 pence. The U.K. currency fell to 137.45 yen from 138.49 and to 1.6199 Swiss francs from 1.6326.

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The Bloomberg article points to HSBC’s woes as a cause for Sterling’s weakness. Don’t be fooled. Everyone knows that printing money and strong currencies don’t mix. Because Mervyn King is going out back to his garden to his money tree to pluck off a few billion in notes to pay for Gilts, currency traders expect higher inflation down the line.   And that means the British currency is worth less.

On the other hand, that does not necessarily mean that interest rates must rise. After all, the BoE is buying up gilts and artificially suppressing their yield. Yet again, Bloomberg seems to miss this connection.

U.K. 10-year gilt yields slid to the lowest level in at least 20 years and the pound fell as bank shares tumbled and policy makers prepared to buy government bonds to inject cash into the shrinking economy.

Yields on gilts maturing from five years to 30 years dropped after Lloyds Banking Group Plc ceded control to the government and HSBC Holdings Plc sank as much as 14 percent in London trading. The Bank of England said March 5 it plans to spend 75 billion pounds ($104 billion) buying corporate debt and government assets that have between five and 25 years to mature.

“This banking-nationalization talk is keeping banking stocks well depressed and that’s supportive for gilts,” said Orlando Green, a fixed-income strategist in London at Calyon, the investment-banking unit of France’s Credit Agricole SA. “The five- to 25-year part of the curve is going to be well supported given that quantitative easing is going to be centering around the 10-year region.”

The 10-year gilt yield dropped as much as 11 basis points to 2.95 percent, the lowest level since Bloomberg began tracking the data in 1989. The security yielded 3.05 percent as of 1:18 p.m. in London. The 4.5 percent note due March 2019 rose 0.05, or 50 pence per 1,000-pound face amount, to 112.37.

The yield on the security posted its biggest two-day drop since at least 1989 in the final two days of last week, shedding 58 basis points, after policy makers announced the asset-buying program on March 5 and cut the main interest rate to 0.50 percent, the lowest level in the bank’s 315-year history.

To my mind the price action in currencies and Gilts has everything to do with quantitative easing and much less to do with bank stocks. The Bank of England is committed to supporting its economy by lowering the price of credit.  Quantitative easing means a depreciating currency and lower interest rates.

Let’s see what effect this has down the line.

Sources
Quantitative easing – FT.com
Pound Falls Against Dollar, Euro as HSBC Drops on Loans Concern – Bloomberg.com
U.K. 10-Year Yield Drops to Lowest Since 1989 on Bank Concern – Bloomberg.com

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