Each year since the financial crisis, most forecasters have overestimated both economic growth and inflation and 2015 began with what is rapidly becoming a tradition as the International Monetary Fund once again cut its forecast for the world economy. Government budgets are constrained by the consequences of years of subpar growth and interest rates are already at rock bottom levels. The fall in the oil price threatens another period of falling consumer prices as it makes its way through the system. With the limits of conventional stimulus policies already reached, quantitative easing (QE)—in which a central bank buys assets from the private sector, thereby boosting the quantity of money in the system—has increasingly become the norm. Its success or failure will determine the fortunes of investors.
The European Central Bank’s announcement of a programme of QE at its January meeting means that the eurozone has joined Japan, the United States and the United Kingdom on this global standard. In spite of German misgivings the programme will involve buying sovereign bonds at a rate of €60bn per month, thereby putting more money in the hands of banks and the private sector in general. The hope is that this injection of cash will lead to more borrowing and spending. The intention, of course, is to support growth and employment in Europe where, ever since the financial crisis, recovery has failed to gain traction.
On the face of it this is good news for investors. Both bond and stock markets have rallied—European stock markets are now at the highest level for years and long-term interest rates, which were already very low by past standards, have fallen again—resulting in capital gains for bond holders.
It has, however, done something else besides: it has reduced still further the prospective return on safe assets. No longer can investors find a quiet corner where, in exchange for accepting modest returns, they were once able to opt out of the risk and volatility involved in, for example, stock market investments. Switzerland—which earlier in January demonstrated that it was not prepared to go along with the eurozone’s burgeoning monetary experiment and abandoned the Swiss franc peg to the euro—now charges holders of Swiss francs 0.75 per cent a year. The longer you invest the less money you have at the end—the financial world turned upside down.
Uncertainty is so integral to investing that the idea that there is a direct relationship between the riskiness of an investment and its prospective return is one of the linchpins of academic investment theory. It is also true, as generations of investors have learnt to their cost, that the investments which appear most solid and certain at the time often prove in retrospect to have been among the worst. Navigating between these sometimes apparently contradictory propositions is a challenge without a simple solution.
While uncertainty is a constant, the form it takes changes. Since the financial crisis of 2008 world economic growth and inflation have consistently come in below expectations and governments and central banks have resorted to more and more unconventional measures to try and jump start economies. The result has been a relentless decline in interest rates, in many cases to the lowest levels ever recorded. Short-term interest rates in a growing number of currencies—the Japanese yen, the Swiss franc and the euro among them—are now negative, meaning that when you deposit money you receive back less than you originally lent. In several bond markets, including the UK, long-term inflation-adjusted interest rates are also now negative, ensuring that investors in these instruments, however much they may have benefited in the short run, will over the long term surely lose purchasing power.
This poses some very particular difficulties for investors—the price of safety has soared to such an extent that “safety” now means guaranteed losses. Inflation-linked bonds and cash deposits have in the past provided modest but still positive returns. These options are no longer available. Risk averse investors, or those seeking a low-risk home for some part of their portfolios, now face a dilemma. They need either to accept that their investments will almost certainly lose value or be prepared to take higher risks just in order to break even. Savers are forced to become speculators or face a slow liquidation.
This unattractive—some would say unfair—state of affairs is quite deliberate. The object of current policies is to make cash and risk-free investments an embarrassment. It is hoped that the feeling of money burning a hole in the pocket will ignite those economic animal spirits which have so far proven to be such damp squibs. Although that may sound rather feeble it should be pointed out that this comes about as close to a theory of quantitative easing as one is likely to find. Indeed Ben Bernanke, the outgoing Chairman of the Federal Reserve and one of the first central bankers to initiate a quantitative easing programme, last February famously quipped that “The problem with QE is that it works in practice but it doesn’t work in theory.” Even as it stands, the comment about it working in practice is perhaps true of the US but rather less certain elsewhere; Japan has implemented a variety of monetary programmes without avoiding a prolonged period of very weak economic growth.
Although there are sceptics, the current consensus tends towards thinking that the problem with QE is that there is not enough of it—or at least that in a world of very low inflation it is a very low-risk strategy. Seen from a different perspective, however, what is immediately striking is that it appears to start at the wrong end. Conventionally, money does not create activity, rather it is the reward or consequence of it, or perhaps the lubricant in the machine; in this case the monetary tail is expected to wag the economic dog.
Notwithstanding Bernanke’s belief that, in the US at least, QE worked in practice, there are legitimate concerns that it might not work so well in other circumstances. With so many economies struggling to maintain altitude much rides on the success of this untried policy.
Whereas the stakes are high in Japan, which finds itself back in recession once again, they are still higher in the eurozone. Various forms of financial intervention have so far succeeded in defusing a series of financial crises but prolonged recession now poses a more intractable set of problems. Reductions in interest rates and promises of “whatever it takes” tranquilised financial markets but austerity and high levels of unemployment are now taking politics beyond where either the central bank or the established political parties hold sway. While the rise of Syriza in Greece and of Podemos in Spain—the two leaders shared a podium at a rally in Athens just before the Greek elections—are a challenge to the status quo, it is the French elections in 2017 that are concentrating the minds of Europe’s elite. If continued recession delivers victory to Marine Le Pen of the Front National, then the euro faces its most serious existential threat yet.
Evaluating the prospects of success for the eurozone’s version of “wag the dog” economics is not easy. In the US, quantitative easing was accompanied by big falls in interest rates as well as by falling risk premiums, meaning that poorer quality borrowers also saw their borrowing costs fall.
In the eurozone, interest rates are already very low—German two-year interest rates are a negative 0.19 per cent and even 10-year government bonds yield only 0.36 per cent. With the exception of Greece, the borrowing costs of the other European governments had collapsed before the programme was implemented; even Spain borrows at less than 1.5 per cent. It’s hard to know how important the effect of falling interest rates was in the case of the US but clearly this is not a following wind on which the eurozone can hope to rely to the same extent. Where the announcement has been more effective is in weakening the euro and this will, in line with conventional theory, tend to support economic growth. While helpful, the fall seen so far will not on its own be enough to reduce unemployment sufficiently to draw the sting of radical politics. QE shorn of its interest rate and currency consequences will need to demonstrate that it has some potency of its own.
With risks apparently so skewed in the direction of economic activity being too weak and inflation too low, policy has moved relentlessly in one direction with perhaps little thought of the road back. The US Federal Reserve had a nasty shock in 2013, the so called “taper tantrum,” when it indicated that it would begin to reverse QE. Long-term interest rates rose sharply and the economy slowed abruptly. A lot of verbal reassurance and still lower interest rates were required to get things back on track. The system in general and investors in particular have become used to very low interest and were rates to return to normal this would impose huge losses on bondholders and probably on owners of stocks and property as well. Prominent among the owners of bonds, of course, are the central banks themselves. Politicians are used to central banks making big contributions to government revenues; clocking up huge losses will not be popular. As usual this is likely to be particularly contentious within the eurozone, where burden sharing between countries is one of the most vexed issues.
Monetary policy has been designed to drive investors out of safe assets, in particular cash, and has so far been fairly successful. Economies are still weak and this apparently costless policy is likely to continue. While it continues, it is likely to support asset prices—indeed this is one of the channels through which, by boosting confidence, it is intended to work. For investors, though, it contains the seeds of its own destruction. The assets that have been the beneficiaries of QE, particularly long-duration bonds, become its victims as soon as the policy is successful, economies take off and interest rates return to more normal levels. Ironically, the sweet spot for markets is the period during which QE is pursued without fully achieving its object. An environment in which investments rise in value as interest rates fall is what we are currently enjoying.
While investors must hope that QE is not too successful, they need to worry about its consummate failure as well. Whereas the attractions of risky assets are boosted by lowering the return on risk-free assets, a sustained period of falling consumer prices reverses the process. As soon as deflation takes hold the real return on cash assets immediately starts to rise. A deteriorating economy and an improving return on cash can rapidly become a self-reinforcing process. For students of the 1930s, including of course Bernanke and the current Chair of the Federal Reserve, Janet Yellen, this represents the sum of all fears.
