Miles Tym
It is difficult to quantify the impact of QE on gilts. Yields fell sharply following the financial crisis, driven by their “safe haven” status in the wake of the demise of Lehman Brothers in September 2008. The response of the Bank of England was to cut Base Rates from 5% to 0.5% in the subsequent six months. Since Quantitative Easing was introduced in March 2009 the Bank of England has estimated gilt yields have decreased by around 0.75%, a reasonable estimate.
The unwinding of QE is tied explicitly to levels of growth in the UK and global economy. The Bank of England has repeatedly implied interest rates will not increase until recovery is well established. The QE programme was suspended in 2012 after purchases of £375bn of nominal gilts although there has been little specific detail on an exit strategy. However, it is likely that growth would have to be similarly well established before any attempts were made to sell those gilts purchased back to the market. Currently maturing gilts in the QE programme are being reinvested to keep the stock of gilts purchased constant and while this continues, interest rates will stay low, with the possibility of a return to QE, if warranted. In the meantime, the Monetary Policy Committee (MPC) appears to be gearing up to use some form of forward guidance on the path of interest rates as its preferred method of keeping monetary policy easy.
The market reacted poorly to a suggestion in the US of a slowing in the pace of US Treasuries purchased as part of their QE programme. There was a sharp sell-off in both Treasuries and risk assets. The re-pricing of yields in US Treasuries was pronounced with yields of nominal bonds 60 basis points higher, and those of treasury inflation protected securities 130 basis points higher. This implies that any attempt by the Bank of England to exit their gilt holdings may risk creating a tighter monetary environment which could threaten the nascent economic growth.
Combined, this would suggest that central banks will tread carefully when exiting QE, and contingent on substantive and sustained growth in underlying economies. It is impossible to predict precise timings as so much depends on unknown political and economic factors including the on-going European crisis and the Chinese slowdown both of which could flare up at short notice, immediately reducing the likelihood of any QE unwind as central banks re-focus on resultant slower growth assumptions and deflation fears.
This will mean a slow and gradual reduction in the stock of gilts held by the Bank of England when global growth is well established and official rates are already increasing. Until then any sale of gilts to the market is unlikely: base rates will have probably risen to 3%-5%, growth would be a lot stronger and gilt yields will therefore already have risen. The impact of unwinding QE in the face of an improving economy and a reduction in the safe haven flows from Europe could result in an increase of yields of 75-100 bps. However, if well flagged this could actually help dampen volatility through providing a pool of assets for investors looking to add duration. In our opinion, the circumstances which would have to prevail before QE was unwound are several years away at present.
So what of the long-term economic yield on long-dated index-linked gilts? We need to establish what the real yield should be and determine which inflation measure this yield should be calculated against. We can assume real GDP growth of 2.25% in the long run as a starting point. However, real rates were significantly above the growth rate during the period when credit was expanding rapidly, and so conversely could easily be less than the growth rate while credit creation is very slow or contracting, as seems likely over the next decade. On a 10 year view 1.5% looks more realistic as a fundamental average. The next question then becomes whether CPI or RPI is a more appropriate deflator. Given that CPI is more like the GDP deflator and more in line with any international comparisons, we are more inclined to CPI. Assuming a roughly 0.75% gap between the CPI and RPI measure, this would give us 0.75% yield on long dated Index Linked. At best we can estimate, the fair level of 30 year real yields should be in the order of 0.75%.
By Miles Tym, institutional gilt fund manager at M&G Investments
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