Despatches  

What will be the consequence of quantitative tightening?

What will be the consequence of quantitative tightening?
Source: Bloomberg

The announcement by the Bank of England that it has increased interest rates to 0.5 per cent generated much heat but very little light in stock markets, as the increase has been expected as part of the pattern of generally rising rates this year.

But the small print of the announcement contained details that may have a profound effect on clients' investments and property assets.

This was the announcement that the BoE will, after more than a decade, begin the process of reversing quantitative easing, a process known as quantitative tightening. 

QE was introduced in the aftermath of the global financial crisis. It involves central banks injecting liquidity into the system through the purchase of bonds. The theoretical reason for doing this is to increase the supply of money in the economy and so stimulate economic growth. 

One of the offshoots of this is that bond prices rise, due to the amount of money injected into the system to purchase those assets. Higher bond prices mean lower bond yields, and lower interest rates. 

According to economic theory, lower interest rates act as a disincentive to save and so an incentive to spend, which may boost economic activity. Meanwhile, lower bond yields are likely to push people out of safe haven assets and into equities, property and other areas that may also have a more immediately positive impact on the economy. 

The impact of QE on equity markets was once described by fund manager Neil Woodford as follows: "If you look at the performance of the economy, then you look at the equity market, the market has gone up by a lot more than the economy, that gap... that's QE."

Bruce Stout, who runs the £1.7bn Murray International investment trust, says the reason asset prices rose at a faster pace than the economy grew is that “you can take a horse to water, but you cannot make it drink”.

By this he means that while one can encourage people to spend more, they will not if they do not feel confident enough to do so, for example as a result of government pursuing spending cuts, as happened from around 2009 onwards, just as the impacts of QE were being felt in the market.

By keeping interest rates low, QE should have helped make houses more affordable, but the effect was to push asset prices higher at a pace faster than wages rose, creating issues in the housing market.

Reverse course 

Alongside the interest rate announcement, the BoE confirmed it will not buy any further government bonds until at least 2023, and will also sell about £20bn of the corporate bonds it already owns.

The US Federal Reserve has indicated it will also embark on a process of reversing QE over the coming year.

Deciding not to buy any more of the bonds has the effect of pushing bond yield up. This is because as bonds the central bank already owns mature over the period between now and 2023, the likelihood is the government will issue new bonds in order to return the capital to the central bank on the bonds that are maturing within the next two years.