You’ve got to hand it to those bankers.
They’ve managed to freak out the financial markets again. Their prize is – you’ve guessed it – another big wad of money.
Over the next four months, the Bank of England is going to hand a £75bn cheque to our banking system, as it launches the next batch of quantitative easing (QE2).
At first glance, the stock market loved it. The FTSE 100 jumped by almost 4%. And yields on UK gilts fell. The Bank would argue that this is just what it wants to see.
But the bad news for the Bank – not to mention the rest of us – is that this is just a short-term reaction. QE2 will do more harm than good. Here’s why…
Why is the Bank launching QE2 now?
What’s QE all about? In short, QE is when a central bank electronically creates money that didn’t previously exist to buy bonds from investors and commercial banks.
This in turn raises cash balances at those banks. The hope is that injecting the system with more money will lower its price, i.e. drive down long-term loan rates. This should spur investment and lending elsewhere in the economy.
The first £200bn batch of QE was injected into the system two years ago. This latest dose wasn’t a huge surprise – the Bank has been dropping hints for a while that more QE was on the way. But at £75bn, the amount was higher than generally expected, and it’s arrived earlier.
Why now? The Bank says it has three big worries. First, global economic growth is slowing fast. This is bad news for Britain. Falling foreign demand for our exports is making these much tougher to sell. That is hurting our manufacturing industry. Up until recently, that’s been the main thing driving what little recovery we’ve had.
Second, UK consumers are becoming more and more cash-strapped, as we wrote about yesterday. This is squeezing spending and slowing growth even more. And both businesses and consumers are finding it hard to get credit.
But the biggest problem in the Bank’s eyes is the eurozone. Greece is on the verge of defaulting on at least part of its debts. Other eurozone nations may follow. So the banks that have lent money to these countries are also in trouble.
Uncertainty over who will be hit hardest is making banks nervous of lending to each other. This is ‘counterparty risk’ in action. But the bottom line is that it is “resulting in severe strains in bank funding markets”, says the Bank.
Are we heading back to 2008?
In other words, history is repeating itself. When the Great Recession hit in 2008, lots of bank balance sheets blew up. That’s because they were stuffed full of loans that couldn’t be repaid – and shouldn’t have been made in the first place. So the banks needed huge bail-outs and oodles of taxpayer cash to keep going.
Yet although they’ve had a second chance, the bankers have now dug themselves into a similar hole. This time it’s their eurozone loans that are going toxic and blasting big holes in their balance sheets.
And by bleating loudly about those “funding strains”, they’ve persuaded the Bank to start another QE-funded bail-out. Nice work if you can get it.
Sadly, though, what’s good for the bankers is far less helpful for the rest of us. This extra QE is likely to do more harm than good to the economy. And even share prices – which soared after QE1 in March 2009 – are unlikely to benefit much either this time around.
Take a look at this chart.
Source: Bloomberg
The purple line starting in March 2009 shows QE I, which reached its £200bn level by year-end.
As I noted above, QE involves the Bank of England buying bonds. So you would expect yields to fall (yields drop when prices rise). This is how QE is meant to drive down long-term borrowing costs.
Yet this part didn’t go according to plan. The blue line shows the yield on UK 10-year gilts. Before QE I was launched, this dropped sharply in anticipation of the Bank wading into the bond market.
But from the moment QE I began, the gilt yield started rising again. Between March and December 2009, it actually rose from 3% to 4%. So rather than pushing down long-term loan rates, QE drove them up. Not good for the economy.
QE2 will push inflation even higher
Why was this? Look at the red line for the answer. That’s Britain’s inflation rate. Six months after QE I kicked in, our cost of living climbed sharply.
The banks didn’t lend out their QE windfall into the economy: small businesses and individuals didn’t see any benefit. Instead, money was punted in places like commodity markets. In turn, that pushed up food and fuel costs – and overall inflation.
Further, QE meant more pounds sloshing around. This extra supply of sterling lowered our exchange rate, making our imports pricier and adding to inflationary pressure. In total, it was more economic bad news.
Fast forward to today. Again, the 10-year gilt yield has been falling in expectation of QE II. But this time round, inflation is already much higher than gilt yields. Even worse, it’s still rising. The Bank itself admits that our cost of living will top 5% before the end of this year.
As the gilt market starts to factor this in, yields here could surge. That would drive up long-term loan rates, which would be very nasty for borrowers. Throw in a weaker pound, and our inflation rate could still climb much higher. Particularly if commodity prices continue to rebound from their recent plunge.
All in all, then, QE II looks like being really bad news for non-bankers. Anyone who was feeling the pinch of higher living costs before yesterday will be feeling it even worse in the months to come.
So what about stocks? Yes, prices rallied yesterday. But when investors stop to think about the damage QE II will do to consumer spending and to company profits, they could soon reconsider. The Bank’s latest action is not likely to be a positive for shares overall.
But some solid investment opportunities may still crop up. We looked at the damage that central banks can do in last week’s magazine cover story. And we suggested some stocks that could be worth holding in spite of that.
Category: Economics