The Quantative Easing Stategy

Posted on: 16 February 2009 by Gareth Hargreaves

Financial expert Graham Kerner takes a look at the key financial and economic issues touched on in the press over the past week.

The Times reported that on Wednesday, Mervyn King, Governor of the Bank of England, admitted that Britain was in a “deep recession” and signalled that the Bank was ready to start “printing money” as soon as next month under an aggressive “quantative easing” strategy to limit the slump.

This is likely to involve boosting the “broad” money supply by buying in gilts, corporate bonds and other assets from the private sector and paying for it by expanding the Bank of England’s balance sheet as suggested in The Sunday Times. Mervyn King’s announcement hit sentiment toward the pound as it lost ground to both the euro and the dollar.

Over the week, the pound fell 2.6 per cent against the dollar and 1.9 per cent against the euro.

However, the pound wasn’t the only currency to face difficulty as currencies of central and Eastern Europe have taken a battering in light of large current account deficits and a growing concern over how some of these countries will facilitate their external debt. Poland, the Czech Republic and Hungary have external debt bills this year of about £100bn, according to ING Financial Markets and Hungary has been forced to seek help from the International Monetary Fund to meet repayments and its currency now stands at an all time low against the euro.

The Polish zloty and the Czech koruna are at five and three year lows respectively against the euro as lending to emerging economies continues to decline. According to the Institute for International Finance, net commercial lending to emerging economies declined from $410bn in 2007 to $67bn in 2008, and is forecast to switch to an outflow of $61bn this year.

Action was being taken both sides of the Atlantic as the House of Representatives approved a revised version of the Bill to revive the US economy. The American Recovery and Reinvestment Act is the largest spending plan the US has ever seen and said to be worth $787bn.

The Daily Telegraph revealed that the package will combine tax cuts (38 per cent of the package), aid to struggling States (38 per cent) and central government spending (24 per cent). President Obama reinforced that the Bill was “only the beginning of what we must do” to turn the economy around as his advisers began sketching a bold agenda for the next 12 months that will include help for homeowners and an overhaul of financial market regulations.

News of the plan was delivered in a speech on Tuesday by the US Treasury Secretary, Tim Geithner. However, the speech was surprising short of detail and the markets did not take the uncertainty well, with the Dow Jones Industrial Average recording its worst one-day fall in two months – tumbling 382 points. Over the week the Dow fell by 5.2 per cent.

The eurozone fared little better, as data revealed on Friday showed the slump of last year was even steeper than feared and that countries in the eurozone could face their worst recession for 50 years. Gross Domestic Product (GDP) for the eurozone fell by 1.5 per cent in the fourth quarter – led by a sharp deterioration in Germany, as highlighted in The Financial Times. German GDP contracted by 2.1 per cent in the final three months of 2008 – the worst quarterly performance since the country was reunified in 1990.

Germany’s weakness has been its dependence on exports rather than house prices, which have barely moved in recent years. French GDP fell by a relatively modest 1.2 per cent in the fourth quarter and the country is not technically in a recession (defined as two consecutive quarters of negative growth), as private consumption supported growth last year.

Italy though has followed a similar path to Germany, contracting 1.8 per cent and for the third quarter in a row. Spain, a country affected more than most by falling house prices, reported a fall in GDP of 1 per cent on Thursday.

With little sign of any rebound in global or European fortunes, The Financial Times suggested the European Central Bank (ECB) may cut its main policy rate by another half per cent next month to 1.5 per cent and that the ECB could soon follow the US Federal Reserve and the Bank of England in taking additional ‘non-conventional’ measures to boost the economy - for instance, by buying corporate debt.

As you might expect, markets didn’t react positively to a shrinking eurozone economy and the German Dax index fell 5 per cent over the week, the French CAC 40 fell by 4 per cent and Italy’s Comit 30 ended 3.5 per cent lower.

It wasn’t a good week for UK markets either as the FTSE 100 shed 2.4 per cent. This was mostly caused by the ever more volatile banking and financial sector stocks. Over the week the Life Insurers sector ended 11 per cent down and banking sector stocks fell by 8 per cent, half of which occurred on Friday following the announcement by Lloyds of a HBOS £10bn loss.

News on Friday that HBOS had suffered a worse than expected loss in 2008 sent Lloyds’ share price tumbling 32.5 per cent - down by more than 40 per cent over the week. Lloyds Banking Group acquired HBOS as part of rescue package following revised competition laws by the government, which approved the take-over and the creation of a British ‘super-bank’.

However, the £10bn HBOS loss was not the only surprise as both Lloyds and the government have faced criticism that the merger may have been rushed and did not allow enough time to properly assess the toxic assets of HBOS. The larger than expected loss was mainly a result of a ‘more conservative’ approach to valuing policies on the corporate loan book.

As reported in the weekend’s Financial Times, this includes loans to companies and commercial real estate and doubled from a loss of £3.3bn in December 2008 to more than £7bn today. However, in a move to provide reassurance to investors, Lloyds said it was expecting profits for the whole group of £1.3bn in 2008.

Lloyds was further in the news over the proposed £120m bonus payments to staff, even though it is “on the brink of state ownership”, according to The Sunday Telegraph.

The UK Treasury owns a 43 per cent stake in Lloyds and they have seen the £17bn injection, made in October last year, fall to a value of just £4.6bn today. The proposed payouts would be distributed among thousands of workers in Lloyds retail and commercial banking businesses.

Bonus payments were also part of the scrutiny ex-bosses of Britain’s largest banks faced this week in front of the House of Commons Treasury Select Committee. The meeting was arranged to find out the causes for the crisis affecting the banking sector. It also unearthed some possible solutions to the bonus system now so much in the public eye.

Jobless Numbers Rising

Unemployment figures released show that the number of people out of work increased by 146,000 in the three months to December, as reported in The Sunday Times. This raises the total number of unemployed to 1.97m – the highest figure for 12 years.

Some of the largest job cuts announced over the previous week came from Royal Bank of Scotland, which said that it was shedding 2,300 jobs as part of restructuring. Swiss bank UBS announced plans to cut 2,000 more jobs as it unveiled huge losses for the final three months of 2008. Preservation of some 5,000 plus jobs is being worked on by Deloitte – administrators of Stylo, which owns shoe shop chains Barratts and Priceless.

Stylo has stated that both stores were still ‘heavily lossmaking’ and had not been able to reduce rent costs. Deloitte are now looking to sell both businesses as a going concern in order to preserve as many of the jobs as possible.

Chinese Move In For Rio

Investors in Rio Tinto are unhappy with the company’s cash injection from the Chinese state owned metals group Chinalco. Legal and General Investment Management is Rio’s second biggest shareholder and they appear unhappy with their holding being diluted by the deal and plans to sell stakes in some of the company’s prized mines and issue £7.2bn of convertible bonds to Chinalco.

The move by the Chinese Government is an attempt to keep commodity prices low, whilst shareholders of Rio want to obtain the highest possible price. Chinalco has been Rio’s biggest shareholder since February 2008, which was a move to stop a hostile bid by rival mining company BHP Billiton.

The Chinese Government was worried that the combined mining companies would have too much power over prices of iron ore supplies to Asia.

Cash Injected

Standard Life has injected £100m into its Pension Sterling Fund after it lost 4.8 per cent in one day in January. The fall surprised investors who thought they had invested in a pure cash fund.

The Financial Times Money section confirmed that approximately 44 per cent of the fund’s assets were invested in floating rate notes – asset backed securities that can, and did, fall in value. The £100m injection will ensure that all investors have the value of their investment restored.

Small Comfort For Savers

The Bank of England has forecast that inflation, measured by the Consumer Price Index, will see a sharp drop over the next two years – falling from its December 2008 level of 3.1 per cent to 0.5 per cent and below the Bank’s target of 2 per cent, reported Financial Times Money.

Inflation as measured by the Retail Price Index, which includes the cost of mortgage payments, has dropped to 0.9 per cent. This offers some comfort to savers, who have witnessed interest rates falling and negative real returns following the deduction of tax and taking account of inflation.

For example, an account paying 3 per cent would provide a real return of just 0.9 per cent following the deduction of higher rate tax and the 0.9 per cent retail price index figure.

A lot of savers are likely to be receiving less than 3 per cent following a number of cuts to the UK base rate and this could get worse if further interest rate cuts are made - as is widely anticipated.

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