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The Hidden Costs of Quantitative Easing or “As An Actuary You Are Having Sleepless Nights”

Posted by Larry Doyle on October 6, 2010 9:03 AM |

When central banks hint at implementing further quantitative easing and risk-based assets (commodities and equities) rally and interest rates fall (meaning, bonds rally as well), this is all good, right? If that is the case, is it even better when the hints become an outright statement of plans for more quantitative easing as was the case yesterday with The Bank of Japan? (WSJ: Central Banks Open Spigot; October, 4, 2010)

Clearly, the global central banks are launching these new volleys of quantitative easing in an attempt to forestall deflationary pressures at work underlying our global economy. That said, while asset markets are rising, we need to be aware there are very real costs to this ongoing financial experiment. What are the costs?

First and foremost, currency weakness leading to lessened purchasing power of fiat currencies. We witness this reality in the ongoing rally of precious metals, primarily gold. There is a second cost which is very real BUT is receiving precious little attention. What is this cost? The increasing likelihood of a crippling of companies with fixed pension liabilities. How so? Let’s navigate as the Financial Times addressed this enormously important topic yesterday in writing, Bond Yield Alert for UK Companies:

Half of all UK companies are heading for bankruptcy if government bond yields remain at their current levels, according to Paras Anand, head of European equities at fund manager F&C.

What do you think of them apples? Half of all UK companies? Where are the rating agencies? Do not think for a second that this analysis does not apply to an array of companies in the United States, as well.

Ten-year gilt yields have fallen below 3 per cent, little more than half of the 5.5 per cent high they traded at in July 2007 prior to the financial crisis, in line with a rally in perceived safe haven sovereign debt.

Amid mounting talk of a growing bond market bubble, Mr. Anand argued if anyone believed such yields were sustainable, then they should also be factoring in the failure of a host of UK companies with large pension scheme liabilities.

“Probably the majority of assets, especially in defined benefit schemes, would be in some form of bonds. The assumptions for returns on these bonds would probably be in the order of 4-5 per cent,” he said.

“If you genuinely believe that bond yields will remain at [current] levels then half of UK companies are bust. As an actuary you are having sleepless nights.”

Mr Anand said the rally in “low-risk” government bonds was partly driven by the “greater fool” theory, in this case a view that central banks would step in as marginal buyers as they conducted a second round of quantitative easing.

As we kick the can down the road, I beleive it is painfully obvious we are merely setting the table for more bailouts and an increasing level of defaults and outright bankruptcies.

We hear little to nothing from our financial wizards around the world on this very serious topic, but it is very real and it is not going away. Will these companies write down their presumed returns on their fixed income investments to the current prevailing level of rates? Not a chance. How might they address the growing gap in their asset-liability match? They will roll the dice, employ increasing degrees of leverage, and reach for yield in riskier market segments.

Hey, wait a second. Weren’t those the strategies which largely led us to our current crisis?

Yes, indeed.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. As President of Greenwich Investment Management, an SEC regulated privately held registered investment adviser, I am merely a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.

  • Dan

    Why worry about it today if we can postpone it and worry about it tomorrow?

  • Bruce

    If nobody really talks about expected losses does that mean they may just go away? Half the companies in the UK? Wow. That’s a lot of companies. Who is going to bear the brunt of this pain? OUCH.

    • fred

      Bruce,

      Those losses reflect current asset allocations in cash, fixed income and equity investments. I think “the plan” is to chase cash and fixed income into equities thereby shifting return expectations higher.

      The problem, as long as inflation (cpi) remains below 2% the result is PE compression and subdued equity returns, that is why the Fed and other central banks are trying so hard to reflate the economy by reigniting inflation.

      With the huge amount of QE that has and will occur, this strategy is akin to striking a match near gasoline, do we really want to risk awakening the sleeping giant?.

      These times we live in are anything but boring!

  • Jeffers

    Hey Larry, why does central bank intervention push bond rates down? Is it simply more buyers than sellers when QE roles around or have i missed a point?

  • LD

    That’s it in a nutshell. If the Fed or anybody else announces it will put at least a few hundred billion dollars if not multiples of that into buying bonds, then bond prices aren’t going down, and rates are not headed higher barring an unforeseen event.






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