Confidence is returning to the UK equity market. Stabilising economic indicators and a successful London Group of 20 summit have helped lift spirits on the City’s trading floors.
With the FTSE 100 up 14 per cent since its March 3 low, there is even talk that the seventh bear market rally since the start of the financial crisis in August 2007 could turn into a bull market. A bull market is defined as a rise of 20 per cent from a recent trough to peak.
There are, however, reasons to be cautious. Thousands more jobs were shed at UK companies this week and forecasts for gross domestic product this year remain bearish. In addition, one market is not performing the way policy-makers had hoped – and it is crucial to the broader recovery.
The government bond markets have seen yields rise sharply in the past two days. This means that yields on benchmark 10-year gilts are now about half a percentage point higher than the lows they touched just after the Bank of England announced its quantitative easing plans on March 5.
QE involves the Bank buying up to £75bn of gilts and investment grade corporate bonds. The lion’s share of the programme centres on gilts – of which £19bn have already been bought.
The Bank of England has only purchased £314m of investment grade corporates since the launch of QE.
The Bank has to bring the gilt, or risk-free rate, lower in order to depress corporate borrowing costs.
But 10-year gilts – at about 3.42 per cent – are a long way off levels the Bank needs to induce so-called “real money” investment funds and insurance companies to sell government bonds. This is thought to be about 2.5 per cent.
So far, the bulk of the sellers of gilts since the first reverse auction on March 11 have been hedge funds and bank proprietary desks.
These groups are in the business of making quick profits by selling gilts at high prices and buying them back at low prices. This has no impact on the corporate lending rates that must fall in order to get the economy moving.
This is why the real money accounts are so important: it is hoped they will sell their gilts and then buy corporate bonds, leading to the all-important outcome of lower company borrowing costs. It is also hoped that a falling risk-free rate will depress sterling swap rates, which measure the cost of switching from a floating to a fixed rate and are used to set fixed rate mortgages.
A senior fund manager at one of the UK’s biggest life insurance companies told me this week: “The spivs [hedge funds] and the props have been the sellers so far.
“I’m not going to sell until we are down to at least 2.5 per cent on 10-year yields. It just isn’t worth my while.”
Highlighting the problems, yields on triple B rated sterling corporate bonds rose this week to 8.2 per cent, also almost half a point higher than the lows they touched just after the QE announcement. Five-year sterling swaps are higher than they were pre-QE.
So what do we deduce from this?
First, QE is proving less effective as signs of economic stability and growing risk appetite have taken away a vital plank that supports the government bond markets. These factors are outweighing the initial boost to gilts from QE.
Second, if yields continue to remain stuck at just below pre-QE levels, the Bank will have to implement a more aggressive policy.
It could do this by stepping up the amount of gilts it buys back at the twice weekly auctions and the amount of corporate bonds it buys.
Even more radically, the Bank could buy other types of securities, such as high yield corporate debt, where there is a serious lack of liquidity, or equities to boost prices and confidence further.
Buying other securities, however, may prove a step too far for a central bank concerned about expanding the money supply too much, too fast. This leaves the less radical option of increasing the size of the gilt buy-back programme. This will still raise the threat of future inflation, but it must surely be worth the risk. Otherwise, if confidence in QE disappears, sentiment could suffer more broadly.
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