Oh dear. Deutsche Bank is already advising its clients to prepare for the failure of quantitative easing in the UK.
In our view, the rescue package is a step in the right direction. However, the time window for the Bank of England to implement its QE could be restricted. Indeed, unlike the US, QE is announced in the UK while the currency is rapidly depreciating. The GBP not having the priviledge (sic) of being a reserve currency, the patience of investors towards the currency could be limited if the government efforts do not yield results quickly. This could force the BoE to stop its attempt of controlling the yield curve. On the other hand, if the policy framework were to partially succeed, the system would be flooded with liquidity leading to inflationary risks.
In our view, the outcome of the policy approach, and further new initiatives taken, would be apparent by the summer of this year. The quantitative easing policy should initially flatten the curve. However, post summer there are significant risks of a sell-off induced either by inflationary expectations or a failure of the QE policy.Rising yields, as we’ve seen over the past week in tandem with widening CDS spreads, generally pose something of a problem for governments pursuing QE — which aims to flatten the yield curve. You can see the issue in US Treasuries from the two DB charts below.
No surprise then, that the analysts at Dresdner are worried of a similar outcome for the US.
The banking crisis has given way to a government crisis which alters the way the market trades. Not only are peripherals within the Eurozone hurt in spread terms, also the absolute yield level is rising. This is not a supply issue per see, but a credibility issue, albeit supply being the catalyst via which bonds are pushed wider. We think the risk going into the fresh week is that even the Fed will not be able to pull off a new stunt that drives yields back down again.
Again, one way of forcing yields down would be for the Fed to start buying long Treasuries — as it has said it is considering. Still, the Fed will have to go in deep to make much of a difference. The risk, as Dresdner notes, is that no matter what it does at this point the market will be disappointed.
And for the UK, there are increasingly bearish noises about sterling. JP Morgan for instance, lowered its forecast for the GBK, moving its estimate for the EUR/GBP top from 0.94 in the second-quarter of this year, to 0.98 — citing the increasing divergence between sterling and the trade deficit (chart below).
… we see little reason to see any imminent turnaround in sterling, particularly as domestic demand will have to contract sharply to improve the trade balance (not, in itself, an obviously positive phenomenon for the currency). In the meantime, the UK will continue to find it difficult to attract foreign capital in the face of near zero rates, slowing cross border capital flows and the inexorable move towards QE.
Related links:
To twist a treasury – FT Alphaville