The news this week that the US Federal Reserve is recommencing its quantitative easing programme on an open-ended basis, and that the European Central Bank is going to start buying the bonds of the peripheral Eurozone States to fulfil Mario Draghi’s commitment “to do whatever it takes” to save the Euro, call to mind an incident in my own investment career just over 20 years ago.
At that time, I was interested in buying shares a small property development company called Bellwinch, in which Iain Duncan Smith, now the Coalition Government’s Work and Pensions Minister, was then a director. My purchase was not a big one – from memory, perhaps between £20,000 and 30,000 – but the market in Bellwinch shares was so narrow and illiquid that I got a call from my broker. “You can only buy in tranches no greater than 5,000 shares,” he told me, “and each tranche will be at a higher price, so your purchases will drive up the price.”
I told him to proceed at this basis, and felt a naive satisfaction when I saw the price increase published in the Financial Times the next day. For the first time, I had managed to move the markets! Furthermore, I was now sitting on a profit on my earlier purchases, which had been at lower prices than the official FT price!
But within 24 hours, the penny had dropped.
If my purchases had pushed the share price up, then, when I came to sell, my sales would also drive the price down – so I would be able to exit from the position, if at all, only at a substantial loss.
This is exactly the position in which the world’s Central Banks now find themselves.
It may explain why Professor David Miles, in his Scottish Economic Society lecture earlier this week, made no comment on when the Bank of England might unwind its quantitative easing programme. Perhaps the Monetary Policy Committee are worried that, if they try to sell off their gilt holdings, it will drive gilt prices down, resulting in large losses for the Bank of England. Even worse, a fall in gilt prices would result in a rise in the cost of servicing the National Debt, making it even more difficult for the Coalition Government to tackle the fiscal deficit.
But at least the Bank of England can be reasonably confident that the British Government will continue to pay interest on its bonds.
The same cannot be said for the European Central Bank. As the ECB buys increasing amounts of peripheral Eurozone bonds, concerns must increase that it may never get its money back. There are very real doubts as to whether the Greek or Portuguese Governments will be in a position to service their debts. Even the solvency of the Spanish Government looks increasingly doubtful.
What of the position of the US Federal Reserve? US Federal Debt has now increased above $16 trillion, and is rising by more than $1 trillion per annum. It is now well above 90% of American US GDP – the tipping point at which Professors Reinhart and Rogoff found that sovereign governments struggle to service their debt, in their analysis of financial crises down the ages.
Private investors are increasingly wary of buying American Government bonds at yields that are negative in real terms. So the only buyer keeping up US bond prices is the Federal Reserve Bank. If the Fed ever tried to sell, it would drive prices down and sustain significant losses.
Even more worryingly, if US Federal debt continues to spiral upwards, there will come a point at which the Federal Government struggles to meet its interest payments. At that point, the solvency of the US Federal Reserve Bank will also be under threat.