The Bank of England yesterday announced a second programme of Quantitative Easing (QE), committing to buy £75bn of conventional gilts over the next four months. The market was surprised by the size (£50bn was expected) and by the timing (November was deemed by the market to be more likely). Overall, therefore, the Bank's action can be seen to be somewhat more aggressive than was generally anticipated. Having digested the announcement, market participants will now try to assess the impact of the programme on the real economy and on financial markets.
On the real economy, our view is that the direct impact will be small. We certainly do not share the Bank's apparent confidence in its ability to accurately calculate the economic impact of QE1 (GDP up 1.5% to 2%, CPI up 0.75% to 1.5%) nor, therefore, do we share the Bank's assessment of the likely effectiveness of QE2. The transmission mechanism of quantitative easing into the real economy is opaque at best.
But more important than the mechanics of the process is the fact that QE does not address the issues that are hindering economic activity. The "hard" issues (excessive debt, fragile banking system) are simply not materially affected by a mechanism which may (and, indeed, may not) maintain bond yields somewhat lower than would otherwise be the case. Interest rates right across the maturity spectrum are at multi-century lows, which renders somewhat improbable the notion that the "price of money " is the problem. Clearly, in our view at least, the problem is not the price of money, but the availability of it; the credit creation process is simply not functioning. The "soft" issues (which concern the confidence of economic players, be they individuals or organisations) are also unlikely to be affected by QE. Of overwhelmingly greater importance is the sovereign debt crisis in Europe, and its direct threat to the solvency of banks. Until a credible solution is in place, confidence will remain conspicuous by its absence.
The impact of QE on the overall level of yields (apart from a very visible initial reaction) is also pretty much impossible to determine - even in retrospect. We will, therefore, not be positioning portfolios to exploit what would be very unreliable forecasts of QE driven yield shifts. What we will be doing is once again profitably exploiting relative value opportunities within the gilt market at the individual stock and yield curve level. These opportunities are an inevitable consequence of the volatility that QE brings to the market and they make for very "high probability" portfolio strategies.
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