On the day that the Bank of England started its Quantitative Easing (QE) regime with the purchase of £340 million of commercial paper under the Asset Purchase Facility, it’s worth remembering why our blog is called Bond Vigilantes, and ask ourselves whether we need to be baring our teeth a little more.

The term Bond Vigilantes dates from the bond market’s aggressive response to President Clinton’s attempt to increase the US budget deficit in the 1990s. The Treasury Bond market selloff (leading to rising financing costs for the US) helped to persuade the administration to balance the budget. Clinton’s political adviser at the time, James Carville noted “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter*. But now I would like to come back as the bond market. You can intimidate everybody”.

I would want to come back as Brad Pitt.

Well, with the collapse of the global economy, budget deficits everywhere in the world have been allowed to expand to almost unheard of levels. Government borrowing in the UK will be about 8% of GDP in the next year, the highest in recent history (it hit 7.7% in 1993-94) and our debt to GDP level is quickly heading north of 50%. The Office of National Statistics has declared that the liabilities of the nationalised and part-nationalised UK banks will have to be added to the UK’s balance sheet, so we could be nearing 100% pretty imminently. At the same time, the Bank of England is starting to print money and central banks everywhere have added to the government’s fiscal stimulus packages with a huge amount of monetary easing (zero interest rate policies). All of this should, on the face of it, be really bad news for investors in government bonds. Fears of a never-ending supply of government bonds, and stories that hyperinflation is on its way, have made many bond investors fearful.

So a good bond vigilante really needs to take a step back from the consensus view that we are going to see a year of weak inflation (perhaps with a period of mild deflation) and then there’s a chance that it’s Zimbabwe here we come. So what are the theoretical drivers of inflation, and is it possible that the consensus could be very wrong this time?

Are you a monetarist or a Keynesian? Monetarist Milton Friedman popularised what is known as the Quantity Theory of Money. In short, the theory simply reflects the idea that if you print more money, the value of that money is reduced proportionately to the amount of money printed. The equation he used was MV = PQ, where M is the amount of money in circulation, V is the velocity of money, P is the price level and Q is the total number of items purchased with the money in circulation. The important thing to note is that there is more than one determinant in the generation of inflation in the economy – the quantity of money is very important, but a rise in this quantity can be offset by a fall in the velocity of money. If money stops moving around the economy (because individuals, banks, and companies are hoarding it) then printing the stuff won’t generate inflation. This spreadsheet here allows you to plug in some numbers of your own to estimate what might happen going forwards – I’m using column C, which allows you to input all factors other than inflation. Thinking about the last year, let’s say that the broad money supply grew by 17.5% (M4), the velocity of money remained unchanged, and the quantity of goods sold rose by 4.3% (volume of retail sales). This results in annual inflation of 12.66%, but UK CPI in 2008 ended at 3.1%. What change in the velocity of money would therefore result in the actual inflation rate? The answer is that a fall in the velocity of money from 5 to 4.575 results in inflation of 3.1%. This is a slowing in the speed of money going around the economy of 8.5%. Assuming that the other factors remained the same, a decline in the velocity of money of 11% would have lead to zero inflation, and anything greater to outright deflation. It therefore follows that even printing money, and doing Ben Bernanke style helicopter drops of dollar bills over the population can’t generate inflation unless we go and do something with that cash.

For the Keynesians, I present the output gap theory. The output gap is the difference between the potential growth in an economy (based on factors like demographic growth in the labour market and productivity improvements) and the actual growth. When an economy is growing below trend, it is difficult to generate inflation – too many out of work employees are chasing too few vacancies, and wage growth is stifled. Unused factory capacity, high stocks of inventories, going out of business sales and empty buildings also keep the lid on inflation. Our favourite economist, Paul Krugman published his analysis of the US output gap and its impact on inflation on his NY Times blog a couple of weeks ago. For every 1% that actual growth falls below potential growth, the inflation rate is reduced by 0.5%. The US Congressional Budget Office is saying that the output gap will be 6.8% over the next two years, which means that the US is staring at a period of deflation, even if you assume that President Obama’s fiscal stimulus fills in a third to half of that growth shortfall.

Finally, thinking back to the UK’s last period of fiscal indiscipline – the 1993 budget deficit of 7.7% – did the gilt market collapse? Well no. 10 year gilt yields fell from 9.7% to 6.1% – a gigantic rally. A selloff did come, but not until the next year, when the Fed hiked rates – something clearly (and explicitly) not on the cards for some time to come. Vigilant yes, panicked, no.

* Note for non-US readers, I believe that .400 is a good batting average in a version of the game that we know as rounders.

Perhaps we shouldn’t have expected to come away in anything but a deep depression from last week’s research trip to see strategists and economists at Wall Street’s investment houses, after all this is the epicentre of the job losses and zero bonuses. At times though, there was a real background hum of anxiety – about their own personal prospects, about the economy and about the future of banking. Somebody once pointed out that the plural of anecdote is not data (except in homeopathy) – but one of the strategists we talked to has bought a gun, in case things get really bad, and one of our flights from London to New York had just 38 people on it.

First then, the banks. Whilst we were there, equity markets had a burst of excitement over talk of the creation of a “bad bank”. But estimates of the size of the “bad” asset pool grow day by day. As one bank analyst put it, there’s $4 trillion of bad assets out there, before you even start thinking about commercial property – so the market’s going to tank if the bad bank is worth only a $1 trillion bailout. (And as a friend who works for a now partly state owned UK bank put it, “why do they want to set up a bad bank? We are the bad bank. They’ve already got one.”) There is a chance that subordinated bank bonds could be rescued by the authorities in the UK, as to allow them all to default could have systemic implications for pension funds and other institutional investors who have significant holdings of the instruments. In the US though, this is not the case – their subordinated bank bond investor base is more speculative in nature (hedge funds, distressed debt players). Bank common equity is now regarded as having only option value, and with no systemic risk, losses can be pushed right up the capital structure. The American public wants to see bank investors (and employees) get punished. The most likely mechanism for this would be through a series of debt exchanges – Upper Tier 2 bonds would be offered terms to convert into Tier 1, and Tier 1 would be offered terms to convert into common equity. Why would investors do this? Well the alternative might be immediate bankruptcy, and the pill would be sweetened with better than current market terms (if you are a distressed debt investor who bought a Tier 1 issue at a price of $45, and you get offered $55 worth of equity, you might well accept). This form of “voluntary” restructuring would not count as an event of default, or trigger CDS contracts, nor would it be seen as the state over-riding the law – President Obama lectured law at Harvard, and the market believes this means that he regards existing property and contractual rights as paramount.

“Regulatory forbearance” is the phrase du jour. There is an argument that the problem isn’t the bad debt, it’s the recognition of bad debt. In a few years time we’ll be through this economic nightmare, and house prices will recover and toxic loans could well end up being money good (the Swedish state actually made money from such assets when it bailed out its bust banks). Why not then keep them marked at 100 on the portfolio, and only mark them down if they actually default rather than showing the low mark to market valuations which are due as much to forced sellers of risky assets as to credit fundamentals? That’s what the US banks did in the 1980s following the Latin American debt crisis, when they were, like now, insolvent. This would allow the banking sector to limp through the next few years, gradually repairing their balance sheets. But under this model they couldn’t start lending again and doing new business – the velocity of money would continue to fall even as the money supply rises, and a prolonged period of Japanese style deflation could ensue. Only “good”, well capitalised and properly solvent banks can facilitate a return to the normality of the lending of the past two decades (if you think that’s desirable). And in the meantime you have to bypass the banking system by putting taxpayer and Treasury Bond investor money directly into the hands of US consumers and businesses.

The Obama stimulus package was coming under a lot of scrutiny whilst we were there. Obama said yesterday that it would be a catastrophe if the Senate doesn’t pass the package quickly – it has has risen from $800 billion to $900 billion in the past week (and now totals 7% of GDP). The original bill had a strong focus on education and transport, and longer term infrastructure projects, but the Republicans want immediate tax cuts which they argue will act much more quickly in stimulating the economy. Away from the package, other ideas for bypassing the banks to get cash into the pocketbooks of Americans included a wholesale cutting of mortgage rates from (effectively state owned) Freddie Mac and Fannie Mae – by cutting mortgage rates from over 6% now, to under 4%, whilst being able to finance those loans by issuing government bonds (yielding around 3%) the government would be able to confer the benefits of the flight to safety in the bond market to homeowners.

Were there any rays of sunshine? Perhaps – at least a couple of economists (Larry Kantor of Barclays, and I see today that the historically very bearish David Rosenberg of Merrills has joined him) are predicting a significant US growth rebound in the second half of 2009. Partly this is due to some rebuilding of inventories after the expected violent destocking of Q1 and Q2, but also there is some expectation that the monetary and fiscal stimulus packages will have had an impact by then. There was also some excitement about the prospects for an early recovery in Asia – particularly in China which announced its own stimulus package (3.5% of GDP) and where direct state control of the banking sector means that lending volumes can be maintained.

We usually visit the Fed when we are in New York – and we did this time too, although we did it as tourists rather than investment managers. You can prearrange a free tour, which includes some exhibitions (including a display for kids which included a 4 page multicoloured book featuring cuddly animals and called “How the Federal Reserve Regulates Banks” which would have made a good photo had our cameras not been confiscated), the screening of an education film about banknote distribution (“Hi, I’m Troy McClure. You may remember me from such educational films as “Lead Paint: Delicious but Deadly” and “Here Comes the Metric System””), and best of all a trip down to the bedrock of Manhattan to see the gold vaults. There’s more gold there than at Fort Knox – $180 billion at today’s prices – but in a fairly small store room. I’m not convinced the stuff should have any value, other than for making trinkets.

Finally inflation. Deflationists hold sway, at least for the short term. There can be no return of inflation until credit demand returns, and we remain deeply in a world of deleveraging and recapitalisation, both on a personal and a corporate level. However, although we were only able to yell a hurried question to the barkeep from the window of our still moving cab back to JFK, it seems that a can of Pabst Blue Ribbon in Welcome to the Johnsons has risen to $1.75, from $1.50 in the autumn and $1 a year ago.

This collapse in growth should not turn into a slowdown as severe as The Great Depression. The scale and pace of the authorities’ response has been astounding, and brilliant. We have done more in the last 6 months than the Japanese did in the first 6 years of their downturn, and we have avoided making the mistakes of 1929 when bank depositors lost their life savings, where taxes were hiked, rates kept high, and where fiscal contraction was preferred over Keynesian expansion. As David Smith of the Sunday Times put it, this is now a battle between King Kong and Godzilla – not a one-sided fight.

However, one thing still worries me, and might tilt that fight in the direction of Depression. Protectionism. In mid 1930, there were some tentative signs that the US economy was stabilising – but then the Smoot-Hawley Tariff Act became law. Going against both a huge consensus of economists (1028 of them signed a petition against the Act), and against the wishes of the President, two Republicans, Smoot and Hawley had huge grassroots support and managed to pass the bill imposing significant tarif hikes on imports to the US. According to Selwyn Parker’s excellent book The Great Crash, global trade effectively came to a standstill at that point and the global growth collapse resumed. Could the US be about to make the same mistake again?

The American Steel First Act would mean that only US manufactured steel could be used for any government project – a clear protectionist measure. On top of this, new US Treasury Secretary Geithner recently came out with this statement: “President Obama – backed by the conclusions of a broad range of economists – believes that China is manipulating its currency”. This could lead to US companies being able to seek import duties on Chinese goods. Could we be approaching our generation’s own Smoot-Hawley moment?

Let me start by restating our opposition to index investing when it comes to corporate bonds (we would say that, wouldn’t we). An equity index is an index of success – as the company prospers and its market capitalisation rises, its weighting in the index increases. Bond indices are buckets of failure. The more a company borrows, the greater its weighting in the bond index. If you follow a bond index, and a company within it doubles its leverage, making its failure more likely, you will have to increase your exposure to that company. Companies like Ford and General Motors were at one stage 23% of the European high yield market – today GM bonds trade at between 15 and 30 cents in the dollar. There is no more depressing sight in the world than a bond fund manager rejoicing in the default of a company because he or she was “underweight” the benchmark. If you don’t like a company, or even a whole sector, don’t invest in it. The index issue might soon become very important for high yield investors, as bank bonds continue to tumble.

We have been very clear on our views on Tier 1 bank bonds over the course of this credit crisis. These bonds just had their worst week ever, with prices down on average around 20%. A new Lloyds 13% Perpetual Tier 1 was issued at a price of 100 on Monday, briefly traded at a 2 point premium, before falling by 50 points by the end of the week, as nationalisation fears accelerated. One broker held a competition to see if this was the worst performance from a corporate bond ever (the “winner” though was a high yield deal issued in the last cycle where the issuing company had a major accounting fraud discovered on the weekend after issue, although at least in this case the sponsoring investment bank made investors whole, taking the loss themselves).

RBS has just had its T1 bonds downgraded to sub-investment grade (BB+ or below). This means that they will enter the high yield bond indices in February, and, when the rating agencies catch up with our internal ratings, there are likely to be many more bank bonds entering the high yield universe.

The European Tier 1 market has a value of Eur 40.7 billion, compared with the European High Yield market which is Eur 49.5 billion in size. On a worst case scenario, Tier 1 could therefore become 45% of the high yield market. This raises a lot of questions – not least, do high yield investors have the skills and appetite to invest in financial bonds (a very different animal to the usual LBO industrial and media names that are the mainstay of high yield investing). Also, will downgrades from investment grade provoke heavy selling from funds which are not allowed to hold high yield?

So more bad news for Tier 1 – but perhaps one crumb of comfort. The prices have fallen to such levels that for some bonds, the bank needs only to keep paying for 2 more coupons before an investor has seen a full return of capital. Whilst full nationalisation of some banks is a step nearer, governments are making it up as they go along, and there is obviously some option value to owning subordinated bank bonds at extremely distressed levels. Full wipe outs can still occur, but the risks are at least a bit more symmetrical at these super-distressed levels.

Thank you very much for a bumper set of entries to our quiz this year. The answers are shown below – with the spirit of Christmas in our hearts we allowed a small degree of ambiguity on a couple of the questions, but in the end the four people who got 19 out of 20 (and the only one they all got wrong was the impossible question 12) didn’t need any charity. Their names were drawn out of the hat and prizes have been awarded as follows:

The Winner: Nicci Dugdale of Myddleton Croft Investment Managers
Second Prize: Joe Wiggins of Principal Investment
Third Prizes go to both Chris Cowell (also Myddleton Croft) and Simon Bullock (Truestone).

Your prizes will be emailed to you shortly. The winner of the M&G staff competition was Laura Brown with a score of 17 – booze will be on its way to you. Congratulations everybody, and thanks for the entries.

1) Reg Varney, star of On The Buses, achieved what banking “first” in 1967?

He was the first person to take money out of a cash machine, at the world’s first ATM at a branch of Barclays in Enfield.

2) Which brand’s name is derived from a phrase meaning avant-garde techniques?

TAG watches – TAG stands for Techniques Avant-Guarde.

3) Five-oh, young-`uns, Bunk. Which city?

Baltimore – the setting for The Wire TV series. Five-oh means police, young – `uns are the juvenile drug dealers, and Bunk is a detective.

4) What had an “e” added to it in 1967 to prevent a diplomatic incident?

Concorde. The French insisted that the French spelling of the word was used when naming the supersonic aircraft, rather than Concord, and the UK government eventually gave in.

5) Christiano Ronaldo’s fashion brand is linked, by chance, with which (will I get into trouble for saying unfashionable?) London suburb?

Thornton Heath, Croydon. Ronaldo’s fashion brand is CR7, the postcode for this part of Croydon.

6) What was the tallest building in the world at the time of the Wall Street Crash?

The Woolworth Building. According to Selwyn Parker’s book The Great Crash, the Chrysler Building become taller a few days after the days which historians generally agree marks the Wall Street Crash (October 24th, October 28th and October 29th, 1929). Some people suggested it was the Eiffel Tower – we are going with Wikipedia as the definitive source on this one, and not counting glorified telegraph poles.

7) According to M&G Retail’s Head of Institutional Sales, Neil Brown, what is the only sport that actively bans left-handed equipment (I have failed to verify this independently, but it sounds plausible)?

Neil claims the answer is hockey, where there is no such thing as a left handed stick. Most people said polo, and apparently left-handed polo play was banned in 1975, so either answer is allowed.

8) Why did Dr. Pepper have a bad November? What’s the worst that can happen?

Dr. Pepper promised every American a can of the vile liquid if Guns N Roses ever released the long awaited Chinese Democracy album in 2008. The record was finally released in November.

9) Data Screws Uplifted (anag.)

Credit Default Swaps.

10) What is this thing called?

Zakumi. It is the mascot for the World Cup in South Africa, 2010.

11) When would Jim Flaherty wear brand new footwear?

He is the Finance Minister of Canada. It is traditional for the Finance Minister to wear new shoes when delivering the Canadian budget (although respondents report that in his most recent budget Mr. Flaherty has stopped the tradition on the grounds of austerity…).

12) What is the lowest unique positive whole number that somebody will pick to reply to this question (i.e. a number that nobody else answers this question with)?

The lowest unique number was 3.

13) Which Las Vegas band is releasing a Christmas single with Elton John this year?

The Killers.

14) Where is the QE2?

Dubai, UAE – it is becoming a floating hotel.

15) What do the following companies have in common? GE, Exxon Mobil, Johnson & Johnson, Berkshire Hathaway, Toyota.

At time of writing they are the only companies rated AAA by Moodys and S&P. We also accepted the answer that they have been Fortune magazine’s “Most Respected Company of the Year”, although all of the contenders for the prizes got the more bond related answer in any case.

16) Following a mix up, the writer of a nature column in a newspaper is sent to cover a war in Africa. Which novel?

Scoop by Evelyn Waugh

17) Which artist produced this work?

Banksy.

18) According to the Handelsblatt newspaper, Germans like ones with an “X” on them, but shun those with an “S” or a “V”. What?

Euro bank notes – the X tells them that they were issued by the Bundesbank rather than by the central banks of Italy or Spain. Germans who fear the breakup of the Eurozone have been demanding only “X” rated banknotes from their banks.

19) Morrissey, Marr, Joyce, Rourke. But who was the sometime fifth member of The Smiths?

Craig Gannon. He toured with the Smiths in 1986 and played on “Panic” and “Ask” alongside Johnny Marr.

20) What did Liverpool FC attempt to copyright this year, to great protests?

They tried to copyright the Liverbird symbol, but had to back down after protests from Liverpudlians who pointed out that it belonged to the whole city.

Shock of the morning wasn’t the overnight Fed rate cut to zero-ish, nor the acceleration of their Quantitative Easing programme, both of which we’d expected for some time. The shock came with this press release from Deutsche Bank explaining that they wouldn’t be calling a Lower Tier 2 (LT2) bank bond. This particular bond, a Euro 1 billion issue, was issued as a 10 year deal, but with a call date after 5 years at the bank’s option in January 2009. Historically, these LT2 issues have been called after 5 years, as if not redeemed then the coupon steps up and theoretically makes it expensive funding for the bank. In this instance the coupon moves from 3.875%, to 3 month Euribor (Euro money market rate) +88bps. This currently equates to just over 4%, so is only a minor increase in the interest cost at a time when refinancing bank debt has become extremely expensive. Subordinated Deutsche Bank credit default swaps are trading at 216 bps, so it makes total economic sense for the bank to have left this relative cheap financing outstanding – to issue a brand new LT2 bond might cost Deutsche Bank a coupon of 5.5 – 6% . Euribor +88 bps is inside where the bank could issue even senior debt.

So it made economic sense, but the market was still shellshocked. The price of the bond fell from around 96 to 90 as the market opened, and other LT2 bonds are obviously under pressure too. Many had felt that there would be a credibility issue in not calling debt at this part of the capital structure, and that it might impair a bank’s ability to issue cheaply again in the future as well as being seen as a sign of weakness. Now one of the world’s biggest banks has taken such a stance however it is likely that every other bank in the world feels able to assess the callability of their outstanding bonds on purely economic grounds (although BNP Paribas did call a LT2 issue today, perhaps before they knew the precedent that DB was setting). All LT2 bonds should therefore be assessed on a yield to maturity (YTM) basis rather than on yield to call (YTC) – in other words the spreads being offered on bank bonds were unrealistically high if quoted to those shorter call dates.

So LT2 bonds are lower this morning, but a bigger hit is likely in the even more subordinated Tier 1 (T1) market. If banks now feel no moral pressure to call the more senior Lt2 bonds, they will certainly have no compunction about letting T1 bonds extend maturity – to perpetuity if necessary. And coupled with the fact that many T1 bonds will not be able to pay coupons if the bank isn’t paying an equity dividend, many investors are going to be left holding zero coupon perpetual bonds. Bond Maths 101 – the zero coupon perpetual bond is the very worst kind of bond you can own. T1 bonds are 10-12 points lower this morning.

It’s that time again. We invite you to take part in the Bond Vigilantes Christmas Quiz. Please send your entries into us by 5pm on Friday 19 December (email link below). The prize is £100 of Amazon vouchers, with second and third prizes of vouchers for £50 and £25 respectively. The quiz is open to all of our readers, clients or not – although M&G staff members will be playing for a crate of beer rather than the main prizes. The questions are designed to be difficult (and to frustrate googling), and you almost certainly won’t need a full house to win a prize (the average score last year was under 14).

1) Reg Varney, star of On The Buses, achieved what banking “first” in 1967?
2) Which brand’s name is derived from a phrase meaning avant-garde techniques?
3) Five-oh, young-`uns, Bunk. Which city?
4) What had an “e” added to it in 1967 to prevent a diplomatic incident?
5) Christiano Ronaldo’s fashion brand is linked, by chance, with which (will I get into trouble for saying unfashionable?) London suburb?
6) What was the tallest building in the world at the time of the Wall Street Crash?
7) According to M&G Retail’s Head of Institutional Sales, Neil Brown, what is the only sport that actively bans left-handed equipment (I have failed to verify this independently, but it sounds plausible)?
8) Why did Dr. Pepper have a bad November? What’s the worst that can happen?
9) Data Screws Uplifted (anag.)
10) What is this thing called?

11) When would Jim Flaherty wear brand new footwear?
12) What is the lowest unique positive whole number that somebody will pick to reply to this question (i.e. a number that nobody else answers this question with)?
13) Which Las Vegas band is releasing a Christmas single with Elton John this year?
14) Where is the QE2?
15) What do the following companies have in common? GE, Exxon Mobil, Johnson & Johnson, Berkshire Hathaway, Toyota.
16) Following a mix up, the writer of a nature column in a newspaper is sent to cover a war in Africa. Which novel?
17) Which artist produced this work?

18) According to the Handelsblatt newspaper, Germans like ones with an “X” on them, but shun those with an “S” or a “V”. What?
19) Morrissey, Marr, Joyce, Rourke. But who was the sometime fifth member of The Smiths?
20) What did Liverpool FC attempt to copyright this year, to great protests?

Click here to email your entry.

The information we collect from you is used solely to contact you in the event that you have won a prize.

This second episode of historian Niall Ferguson’s series on the story of money and finance, The Ascent of Money, is probably worth a look. It’s apparently going to cover the development and importance of bond markets, and although it includes an interview with a minor US bond fund manager rather than one of your friends at M&G, it will be interesting.

Meanwhile it’s time for a quick competition. I’m reading The Great Crash by Selwyn Parker. Whereas Galbraith’s book of nearly the same name (The Great Crash 1929) covers the stock market’s dramatic fall at the start of the Great Depression, Parker takes the story on to the next few years and covers both the policy errors made by the authorities, and the impact on the people who suffered through unemployment and bank failure. In some ways it makes me feel more optimistic about the current economic meltdown, for although we are unlikely to escape a severe downturn, at least the central bankers and governments now “get it”. We’ve now seen an expansion of the money supply and cut rates (money supply contracted aggressively in the 1930s and rates were slow to fall), fiscal stimulus (in the UK they actually put up taxes in 1930), and while in the 1930s banks were almost encouraged to fail, we are now bailing them out, allowing at least a chance for lending to recover. However, we should remember that the US economy did recover a little by 1930, until the Smoot-Hawley Bill was passed, setting up massive protectionist tariffs to keep foreign goods out of America. At this point the global economy went into freefall, and trade almost ground to a halt – the depression deepened again and lasted for 5 more years. Is there a danger that a Democratic US government, wanting to help the automakers for example, makes the same mistakes as Congress and the Senate made in June 1930?

It’s a fascinating book, but Selwyn Parker will sadly suffer the same fate as J K Galbraith, who complained that he missed out on millions of dollars worth of sales of his greatest work as no airport bookshop would stock it.

Anyway – the competition. The prize is a copy of The Great Crash, and it will go to the first person to email me the name of the US Treasury Secretary at the time of the Wall Street Crash – he’s the one who told the President to “liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate…”.

We talked about the possibility of Japanese-style zero interest rate policy (ZIRP) heading to the western economies in a recent blog. Today we had an unexpectedly large rate cut from the Bank of England, with the policy rate hitting 3%, its lowest level since 1955, when Winston Churchill was Prime Minister. In this link to a 3 minute video I recorded this afternoon you can look into my wild, staring eyes and hear me discuss the Bank’s decision and the outlook for bond markets into 2009.

Click here to watch (This video is no longer available)

Later today the Fed will probably cut US rates by 0.5%, down to 1%. After this we’re only a couple of cuts away from a zero percent Fed Funds rate. When rates are at 0%, what can a central bank do to stimulate the economy? Well some possible answers are found in Japan, although with its economy still struggling to print positive growth numbers a full 18 years after its bubble burst, it may not be the best role model. In March 2001, with Japanese short term rates at 0.15%, the Bank of Japan (BoJ) began a quantitative easing programme. With traditional monetary policy no longer effective (the so called liquidity trap), how could the BoJ stimulate economic activity? It flooded the economy with money by buying financial assets (bills, equity, ABS), and in so-called Rinban operations directly buying Japanese Government Bonds. Rinban operations were designed to make monetary policy effective at longer dated maturities than traditional central bank activities. By buying long dated government bonds the hope was that yields would be pulled down across the curve, and thus reduce borrowing costs for corporates and individuals where loans were benchmarked over government bond yields. The BoJ purchased about $120 billion JGBs per year as part of the plan.

Did it work? Quantitative easing ended 5 years later, with the BoJ having reached its stated aim of returning the economy to inflation (although it did subsequently return to deflation once more). Long dated (20 year) JGB yields did fall too, from about 1.8% in March 2001 to below 1% a couple of years later – but by the time quantitative easing came to an end yields were back up above 2% again, so it’s arguable whether this part of the plan was very successful.

Is quantitative easing something that the western economies will consider? Well to some extent it’s already here – central banks have turned on the printing presses (the $80 billion to bail out AIG for example), are flooding the money markets with liquidity, and have started to buy financial assets (the equity stakes in banks for example). Purchasing of US Treasury bonds might not be too far behind – and remember that the Fed discussed it once before around the time of the 2002 deflation scare. The FOMC talked about “unconventional measures” including purchasing many types of financial assets (and non-financial too – it’s rumoured that they discussed using the secondhand car market as a means of getting cash into the hands of the American public). The June 2002 Fed paper, Preventing Deflation: Lessons from Japan’s experience in the 1990s, is well worth revisiting as a route map for the next few years.

And this might well be a story that takes a few years to unfold – it seems difficult for us to believe that the amount of fiscal stimulus, rate cuts, printing press activity and bank recapitalisation thrown at the global economy won’t result in a sharp rise in inflation, but the Japan experience shows that even then the most extreme measures can’t guarantee that the authorities can generate a bit of lovely inflation.