All this currency printing (Dollars, Sterling, Yen & Swiss Francs) by central banks as they engage in their various forms of quantitative easing is leading to a depreciation of their currencies against real assets. This is being disguised by talk of currencies engaging in competitive devaluations against one another but eventually it will show up in the price of real assets increasing as measured against these fiat currencies. By real assets we are talking about Oil, Real Estate, Gold and Equities (the first three of which God ain’t making any more & equities are a claim on nominal GDP). Government bonds are being propped up by heavy central bank buying and may well remain expensive for years (there is no point in fighting concerted central bank buying of government bonds – John Maynard Keynes pointed out that “markets can stay irrational for longer than speculators can stay solvent”). Don’t read too much into “failed auctions” of Government bonds such as happened this week in Gilts – this is a brave new world and market participants are still feeling their way towards what they should be paying the DMO for 40-year gilts when the BoE is busy buying 5- to 20-year paper. The head of the DMO (whose job it is to sell gilts as expensively as possible) should have kept quiet rather than allow himself to be quoted as saying “Yields at these levels are not all that attractive”. However the general idea to issue longer-dated gilts than the BoE is buying back is surely the correct strategy for the DMO to execute whilst gilt yields are this low, even if the execution is proving a little untidy at times.
As usual the ECB is the slowest of the Western central banks to act – they have yet to commence quantitative easing but the central bankers of Portugal, Ireland, Italy, Greece & Spain (collectively called the PIIGS) must be praying for the ECB to start buying government bonds soon as there are few other buyers of PIIGS bonds at the moment and they have lots to sell. The ECB has a practical problem to overcome if & when it decides to implement quantitative easing, namely which eurozone countries does it choose to favour by buying their government bonds? If the ECB wishes to ease tight credit conditions then it should logically buy the PIIGS’ bonds and squeeze their yields back down towards German levels (the great “convergence trade” would be back on with a vengence), in the process helping to allay market fears about any of the PIIGS leaving the Euro. Once could reasonably expect squealing from any eurozone country whose bonds were not purchased by the ECB. Not a pretty problem for the ECB to overcome whilst other central banks already have the printing presses rolling flat out.

Post-Script (23 April 2009) :  One possible way for the ECB to execute Quantitative Easing would be for the ECB to spend its money by buying equal amounts of each eurozone member countries’ government bonds.  In this way the policy could be sold as being “fair” to all whilst having the desired side-effect of a greater impact on the PIIGS due to the smaller size of their economies relative to Germany, France, et al.

One deliberate side-effect of the Bank of England’s quantitative easing program is that their purchases of bonds will be financed by creating central bank reserves.  Literally the UK banks’ combined reserve accounts at the BoE will be credited with £75 bln (created with a wave of the BoE’s magic wand).  The BoE has decided to go down this path, hoping for the following result:

Lets follow the money (always a useful exercise).  A UK bank (lets assume LLOY as a proxy for the UK banking sector) buys £75 bln of bonds in the marketplace (the BoE has indicated this would comprise £50 bln in gilts and £25 bln in corporate bonds).  Assume further that the gilts are bought from institutional investors and the corporate bonds are newly issued by non-bank UK companies.  LLOY pays for these bonds by handing over its depositor’s cash : £50 bln to the institutions and £25 bln to the companies.  The UK companies have therefore just borrowed £25 bln of term money.  Institutional liquidity has just increased by £50 bln – they will want to reinvest this cash in either more gilts (bought from the Debt Management Office, thereby effectively monetising UK Government debt issuance) or corporate bonds or by buying equities.  Anyone still worried about how the DMO is going to sell the mountain of gilts it needs to shift this year can now rest easy.  However in reality LLOY is acting as an agent for the BoE and so LLOY sells the £75 bln of bonds to the BoE.  The BoE pays for these bonds by crediting LLOY’s reserve account with £75 bln.  The BoE pays the Bank Rate on these reserves (currently 0.5% p.a.) so it is going to make a profit on its holding of bonds.  But what about LLOY?  It is paying its depositors far more than the Bank Rate (Libor is still a shade under 2%) so it will take most of the £75 bln out of its reserve account, leverage it up to, say, £150 bln and lend this out to borrowers (10 year gilts at 3% would do nicely as they eat up little Tier 1 capital – there are £590 bln Gilts outstanding and the DMO is going to be selling new gilts like hot cakes!).  Then LLOY can afford to pay its depositors Libor on their £75 bln and still turn a profit.  In reality Libor is going to trend down towards the Bank Rate at the same time. Whether Gilts are over-valued is a question for the future (the view that Gilts offer return-free risk). In the meantime, has the DMO sold all its gilts yet?