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Market Update - September 2012

European Central Bank Bond Purchases

As widely predicted in the press, the European Central Bank (ECB) announced yesterday that it will begin to purchase government bonds in an effort to increase confidence in those markets. This is very similar to the Quantitative Easing programmes which have been used by the US and UK since 2009.

For investors, it is useful to understand how these purchases are intended work and the broader implications.

Firstly bond purchases work by decreasing interest rates. Now that the ECB is a buyer of bonds, there is additional demand for those bonds and this leads to an increase in their price. The increase in the price of bonds leads to a decrease in the yields on bonds, e.g., before purchases commenced bonds are priced at £100 and pay £5 income per year and so the yield is 5% (£5 ÷£100). After purchase the price increases to £110 and the bond still pays £5 income per year so the yield is 4.5% (£5 ÷ £110). So the purchases move the bond yield from 5% to 4.5%. As we’re talking about government bonds this is effectively saying that interest rates have decreased from 5% to 4.5%.

Secondly bonds purchases work by increasing the money supply. The ECB will create money electronically with which it will go into the market and buy bonds. In effect, the ECB increases the money supply by swapping newly created money for assets (bonds). Creating money electronically is the modern day equivalent of cranking up the printing presses – more on that below.

Many of you will know that two of the three factors that I consider to be most important for economies to be considered structurally sound are that 1) its interest rates are decreasing, and 2) that its money supply is increasing. On the face of it then, these would be positive developments for European markets and they have certainly caught the eye. However, there are other structural issues at play which may yet overwhelm these positive moves by stifling the flow of money through the economy such as high unemployment, high taxation and fragile investor sentiment. These are, then, perhaps just the first steps along a difficult road.

Finally, a few words on the longer term implications of bond purchases. Creating money electronically is the modern day equivalent of cranking up the printing presses. History is littered with examples of how printing money eventually leads to an inflationary spiral (e.g., Weimar Germany, Argentina, Zimbabwe, etc.) and this may explain why Germany was the sole voice of dissent against these bond purchases. Inflation is generally negative for those holding cash and bonds when the rate of inflation exceeds the interest rates available which is certainly the case in the UK now. Moderate inflation is usually positive for “real” assets (i.e., the opposite of financial assets such as cash and bonds) such as shares, gold and other commodities.

If you would like to discuss any aspect of this Market Update in more detail or if you would like to find out more about how I can help you navigate the ever changing economic environment, please do feel free to get in touch.

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About Paul Hill

After building an excellent track record working for a FTSE250 Wealth Management firm and a FTSE100 bank he established his own business to better focus on delivering specialised investment management to his clients. Based in Lancashire, Paul provides inv... read more