10-year gilt yields approach 10-year Treasury yields

If I asked you to guess who said this, what would you say?

“We think that a larger part of the impact of QE comes from the initial announcement of the stock of assets to be purchased, rather than the subsequent flow of purchases.”

The answer is perhaps a surprising one, because it sounds cynical, even critical.

Yet, it is Andrew Bailey, the current governor of the Bank of England and the man responsible for announcing QE (quantitative easing, the creation of money in order to buy bonds as a measure to  keep the financial system healthy).

He is essentially saying what many others have realised, which is that a large part of a central bank’s role is communicative. Simply by saying “we will do QE to help the economy recover from Covid”, a lot of the effects of QE are achieved, notably calming the markets and making forecasts more optimistic. Cooling fears in times of panic is a valuable tool, more valuable perhaps, than the creation of money itself.

The word(s) from the governor

Anyway, Mr Bailey has been saying some interesting things of late.

“We have had fairly weak investment in this country for some time now. Infrastructure is an important part of it as it increases the capacity to do business more easily. I think investment is a big part of the story.”

After 2008, QE by central banks was countered by austerity from governments. This time, the economic groupthink is that governments must spend and build and support the economy more directly. QE didn’t create growth – which, in the UK and the United States, has been pretty anemic since the global financial crisis 12 years ago.

This time, conventional wisdom is that growth can be better achieved if governments work with central banks, spending more freely, rather than cutting down on spending and putting the brakes on the economic recovery.

This feels a little like “fighting the last war” – but that is better than perhaps making the same mistake again.

There’s a degree of humility to his pronouncements on inflation. Mr Bailey said:

“We are going to have a very delicate and challenging job on our hands so we have got to in a sense prevent the thing [inflation] becoming permanently embedded because that would obviously be very damaging.

“… We have got some very big and unwanted price changes. Now we would expect to see that revert because people want to go back to their more established patterns, and we are seeing that happening, but it still has quite a way to go. This has been an almost unprecedented set of events. They are not over yet, that we are learning. We have to manage our way through them, and we will do that.”

One of the key debates on inflation at the moment is the extent to which it is being caused by transitory effects, which will subside and normalise. This means things like low comparative figures from last year’s Covid crash (“base effects”) making current year-on-year inflation figures look higher, and also supply chain issues and bottlenecks arising from Covid and the reopening.

The key question then, is to what extent the drivers of inflation will subside, or compound.

US Federal Reserve chairman Jerome Powell has categorically dismissed claims that inflation might persist, in order to justify continuing that central bank’s aggressive monetary support for financial markets.

Mr Bailey is more nuanced and cautious in his view, saying,“What starts out as relative changes in price levels for some goods and services can become generalised and turn into persistent inflation. I take this risk very seriously, it has form so to speak.”

“Meanwhile, just to remind, the recovery is weakening,” he added, ominously.

This recovery – or lack of it – will be discussed further in a forthcoming edition of Exponential Investor.

In the meantime, we’ll just note that softening economic activity and mounting inflation is not a good combination.

Two other quotes from Mr Bailey’s speech are noteworthy.

Firstly…

“We have had to rely on asset purchases to do a lot of the work because of the proximity of interest rates to the lower bound.”

This admits a key weakness in central banks’ arsenal, once interest rates are already at or near zero. You can’t take official interest rates lower.

This is why people fear that if something else goes wrong, the central banks won’t be able to bail investors out again.

And (emphasis added)…

“But all of this group [the Monetary Policy Committee] were of the view that the stimulus to monetary policy enacted in response to Covid would need to start to unwind at some point, that unwind should be enacted by an increase in Bank Rate, and if appropriate would not need to wait for the end of the current asset purchase programme.”

Two different approaches on either side of the Atlantic

So, there you have it – a very big difference between monetary policy here in the UK on one hand and in the United States on the other.

The Federal Reserve is considering reducing (or “tapering”) the asset purchase programme from its current level of $120 billion per month, and then – maybe – raising interest rates later next year.

Here in the UK, Mr Bailey is saying that we could see interest rates rise before QE is formally ended.

What has all this done to financial markets in the UK?

Start by looking at the yield on the 10-year UK gilt bond (shown in red in the chart below).

In January last year, the yield was 0.6% or so. In mid-2020, after the Covid pandemic had emerged, the yield fell to an extraordinary 0.105%.

Currently, the yield is sitting above 1.2% – the highest level since March 2019.

Of course, the price – or value – of a bond moves in the opposite direction to the yield (as the yield goes up, so the price goes down).

Meanwhile, in the United States, the 10-year Treasury bond yield (shown in blue in the chart below) is not quite at a post-Covid high, and still at the same level as in January 2020, just before the pandemic struck.

Divergent monetary policies and divergent bond markets

Source: Koyfin 

Over recent months, the yields on the 10-year gilt has risen by a lot more than yield on the 10-year Treasury bond.

Now, for the first time since mid-2016, around time of the Brexit referendum, the yields on the two bonds are coming close to matching each other.

Coming soon…

… to a screen near you!

There’s not much time to go into detail about crypto markets here and now. However, crypto markets could be in for a shock. Our editors, Sam Volkering and Boaz Shoshan, have convened an urgent broadcast to tell you everything you need to know.

Keep an eye out for that on Thursday.

All the best,

Kit Winder
Editor, Exponential Investor