It is just over a week since the launch of the second round of quantitative easing in the UK. But cracks are emerging already.
One commercial bank was reprimanded by the Bank of England for squeezing gilt prices higher ahead of the first QE2 auction on Monday last week, say bankers, while elsewhere more doubts are creeping in over whether further stimulus can revive financial markets.
It is perhaps too early to make an assessment on whether QE2 is working since only £5bn of gilts have been bought since its launch on October 6. Under this programme, the Bank is to buy a further £70bn of gilts over the next four months to revive the stalling economy. This is on top of the £200bn it bought in round one between March 2009 and January 2010.
But what is a concern so early into the new programme is the manipulation of the market. This is where a bank buys gilts ahead of an auction, in this case the 8.75 per cent gilt maturing in 2017, to push the price higher. It then sells the security to the Bank at a profit.
This is the first time QE has seen such a blatant attempt by a commercial bank to make a quick profit out of the auction process, say bankers.
In this case, the Bank refused to buy the gilt and warned the offending bank over its actions, making it clear to the rest of the market that it was not about to be hoodwinked into buying bonds at artificially high prices in the auctions, say bankers. The Bank does not comment on the auction process.
As an isolated case, such a move, known as gaming the system, does not amount to much. A number of banks were warned over squeezing the market in the first round of QE, although none managed to move prices in such a dramatic way as last week.
But it is a sign of potential problems ahead as gilts become more scarce, forcing the Bank to buy at increasingly higher prices and lower yields. Over the next four months, the Bank’s purchases of gilts will outpace sales by the UK Debt Management Office by an average weekly ratio of £5bn to £2bn.
John Wraith, fixed income strategist at BofA Merrill Lynch, says there could come a point where a number of banks and pension funds refuse to sell their gilts at any price as they need them for liquidity requirements or to match liabilities.
Andrew Roberts, head of European rates strategy at RBS, adds: “There is a law of diminishing returns. As QE goes on, the less bang the Bank of England gets for its buck – and the greater the risk of manipulation.”
The Bank says it will not buy more than 70 per cent of the free float of individual gilts and, once the current QE programme ends, it will have about 30 per cent of this free float in nominal terms.
Many strategists and investors expect a further round to be announced in February. But the limits of QE are approaching. Some estimate that the most the Bank can buy is 50 per cent of the free float. Above this, QE could reduce liquidity and see distortions to prices that could deter international investors from buying gilts. It is a reminder that QE cannot go on indefinitely.
The limits of the buy-back policy are underlined by the fact the Bank is not prepared to purchase a large amount of corporate bonds because it is wary of taking credit risk on to its balance sheet. In total, it has bought less than £1bn in corporate bonds.
Unlike commercial banks, the central bank does not have a team of analysts to assess the risks of buying debt without a top-notch triple A credit rating, such as gilts, which are considered risk-free and extremely unlikely to default.
Richard Batty, investment director at Standard Life Investments, says: “There will come a point when QE purchases must come to an end as there is a finite supply of gilts and the Bank of England does not want to buy corporate debt.”
It must be hoped that UK financial markets and the economy are restored to health before saturation point is reached.
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