Quantitative easing has the Red Bull effect

Posted on: 16 February 2010 by Mark O'haire

The key now to successful investing is in reducing your exposure when the risk is disproportionate.

Do you think it is a good idea to keep any investments in corporate bonds/gilts as I am hearing from some sources that they are a massive bubble.

Bubble? That's a synonym for fizz, and it's ironic that the biggest contributor to it being a bubble is the 'red bull' stimulus injected into the veins of the economy by the Bank of England - quantitative easing.

Quantitative easing is where the Bank of England creates cash in its account, with which it buys up a range of assets from other institutions such as gilts etc, who in turn pay that into their banks and for the banks to supposedly lend it on (it hasn't happened).
It's called liquidity or 'greasing the wheels of finance'.

The idea is that it also drives down gilt/bond yields, which in turn is a thermometer for lending rates which helps the business community from a borrowing perspective. That hasn't happened either, and banks have just sought the opportunity to create the extra margin for themselves to bolster up balance sheets.

Whether or not the fizz will lose its effervescence depends on a number of complicated issues.

If Barack Obama beats the investment banks, much of the inflationary risk will disappear as the cost of the raw goods (commodities) will plummet. Higher interest rates will not be needed to curb inflation so there will be less stress on the financial system and in turn sterling.

Furthermore it is not expected in the short term that the Bank will ease any more red bull into the system as it is widely expected that the current recovery is sustainable in the short term. If it is, investors will be mindful that the treasury could soon sell off its recent purchases driving yields up and capital values down.

Most retail investors in bonds are not sophisticated enough to play the market, moving between the two contrasting holdings of equities and bonds. Instead most hold them as a hedge against each other i.e. buying an ice cream company and a wellington boot company - In extreme conditions they balance each other.

It is well documented that bonds have been the better selling sectors over the last year and it's easy to see why, but the bubble could be losing its fizz and creating a potential bubble.

And if you understand g.i. indices with food, after a sugar spike there is a boring, boring lull with no energy. If you have suffered a sugar spike lull (rice cakes are interestingly pretty bad for that) you will know that you get no warning but that you are crabby and unapproachable.

The key now to successful investing is in reducing your exposure when the risk is disproportionate.

Whilst the above 'depends on what happens' there is a flip side to much of this. Any study of banking crisis will show you that there is indeed a long process of deleveraging where everyone tries to reduce debt down to reasonable levels - even governments.

Undoubtedly the next government will have drastic spending cuts, a strategy that will, along with current employment rates have a medium term dampening effect on inflation. In turn gilt yields will then be allowed to remain low and for much longer than expected, making them still an attractive sector. However, in the short term, inflationary figures driven by Vat changes and the appalling tax on fuel and energy prices will make their way into the system causing short term inflationary problems which I am comfortable will dissipate because of the dampening issues mentioned.

There is evidence already of yields rising with ten year gilts hitting 4% in December from 3.5% - a downward pressure sign on prices. So in short I would take an opportunity to reduce risk by taking some of the gains and keep an eye on inflationary figures around August September time.

By Peter McGahan

Need Expert Advice?

Peter McGahanPeter McGahan is an Independent Financial Adviser and Managing Director of Worldwide Financial Planning. Worldwide has won 16 Financial Times awards in the last four years. Peter has also been named the top media IFA of the year by Unbiased.co.uk in 2009.

Peter comments regularly in major journals such as the Mail on Sunday, Irish News and Sunday Times and is a weekly columnist for FT Adviser. He has also appeared on Working Lunch and the Today programme. In addition he is an expert on international tax matters for a range of international publications.

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Information given is for general guidance only, and specific advice should be taken before acting on any suggestions made. The above represents the personal opinions of Peter McGahan. All information is based on understanding of current tax practices, which are subject to change. The value of shares and investments can go down as well as up.

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