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Peter Seilern: QE or not QE? That is the question

24 October 2019

Peter Seilern, author of “Only The Best Will Do” and chief investment officer of Seilern Investment Management, considers the challenges facing the European Central Bank and what the resumption of quantitatve easing could mean for savers.

By Peter Seilern,

Seilern Investment Management

Discussions rage in the eurozone about the resumption of quantitative easing in the face of negative bond yields and about the purpose it serves.

There are three issues.

First, government bonds in eurozone creditor countries are becoming scarcer. Countries such as Germany or The Netherlands have a different approach to budget deficits when compared with their Mediterranean brethren. The former wish to save while the latter wish to spend.

As a result, Germany’s policy of a balanced budget and her focus on repaying the national debt reduces the supply of new German bonds as the country’s need to tap capital markets wanes. The European Central Bank’s (ECB) return to quantitative easing clashes with its own internal limits on the amount of existing and new bonds of any country it may buy (set four years ago at a limit of one-third of a country’s stock of bonds).

Moreover, the ECB then also committed to buy sovereign bonds in proportion to the size of each eurozone country’s economy and population. Meanwhile, however, yield-hungry capital market investors are likely to underpin the current low level of bond yields, as they have since the ECB’s quantitative easing became more restricted. Even when central bank quantitative easing was placed on hold, longer bond yields remained subdued as marginal institutional buyers ensured their continued low levels. Since these marginal buyers are unlikely to disappear any time soon, discussions about limits, or even about moral hazard, are misplaced given the reality of today’s capital markets. Furthermore, the ECB is placing increasingly vociferous pressure on governments to play their part and re-invest accumulated current account surpluses into infrastructural projects by building schools, hospital and roads. Fiscal expansion, argues the ECB, should co-exist with monetary loosening. It points out that the burden of extracting the eurozone from the last financial crisis was borne entirely by the bank, through its monetary policy, as politicians stood rooted in inactivity. (It is interesting to note how critics expect the public sector to take up the baton rather than insisting on the expansion and deepening of private sector initiatives, as would be the case in the US).

Secondly, ECB critics accuse the bank of monetary financing in which sovereign debt is indirectly underwritten by the central bank. This, they argue, creates moral hazard, potentially on a grand scale. It is no surprise that many of these critics stem from the same thrifty countries who prefer saving to spending. For them, the risk of inflation clearly trumps that of deflation in spite of stubborn signals pointing to the heightened risk of the latter. There have been several high-profile resignations from the ECB’s governing council as its president, Mario Draghi, is replaced by former IMF chief Christine Lagarde on 1 November.

Thirdly, with interest rates negative, little effective ammunition would remain in the case of a deflationary bust. Negative yields may freeze producer and consumer alike into inactivity as each party waits for prices to settle down at lower levels. While the producer’s margins are at stake through falling prices, the consumer would benefit from holding back. Although central banks can, in theory, print money to their hearts’ content, independent from political interference by governments, growing negative yields in financial markets are uncharted territory in which all economic agents are subjected to tapping in the dark, and this would hit pension funds hard. Another serious, even dangerous effect would be that on the banking community and its stock of non-performing loans.

All this serves to highlight the misalignment of pension fund assets required to fund future liabilities. Are sovereign bonds of heavily indebted nations that are earning low or negative yields still the risk-free asset that will provide for our future pensioners’ retirement? Surely this continues to be the ticking time bomb for pensioners. The misplaced fear of where true risk lies in financial markets prohibits pension fund managers from thinking out of the box by seeking to increase returns and reduce risks simultaneously. This seems to continue to go unnoticed, but it is entirely possible. If, pension funds were not only permitted but, further, obliged to increase their weighting in multinational quality growth businesses, this Gordian knot of how to align long-duration assets with long-duration liabilities would be sliced.

It is time for regulators and actuaries to take note and act.

 

Peter Seilern is author of “Only The Best Will Do” and chief investment officer of Seilern Investment Management. The views expressed above are his own and should not be taken as investment advice.

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