Date submitted: 17/02/2012

Is QE working? It depends what you want it to do…

The video and more is available on our blog at http://www.worldfirst.com/blog.

The Bank of England’s decision to increase the level of quantitative easing in the UK economy was by no means a surprise, but the common question that followed the announcement of a further £50bn injection into the economy was; ‘is it actually working?’ To give a typical economist’s answer I will reply by saying simply; ‘it depends on what you wanted this money to do.’

The plan to lower bond yields has obviously worked with the 10yr bond falling by 39% in the past 3 years.  QE works by the Bank buying bonds in the open market with the demand causing the yield to fall and their attractiveness as an investment to fall as well. This has allowed the UK to maintain a level of bond auctions, and public debt, without too much trouble from the ratings agencies or any vigilante bond traders.

From an inflation point of view the result is less certain. Inflation in the UK has remained sticky throughout the crisis with CPI remaining above the Bank’s 2% ± 1% target since January 2010. Mervyn King and the rest of the MPC have been notoriously bad at predicting inflation, expecting it to drop closer to target with every Inflation Report. As I have said before, we think that 2012 is the year that inflation does finally start to move lower and QE will be instrumental that a slip into deflation does not materialise. Falling prices seems like a good thing for you and me; unfortunately the accompanying shift in demand and expectations of further price falls would later prove to be a more painful problem than most would think.

Another concern about QE is whether it has actually helped the economy grow and whether the depression of government bond yields is now worth it. There’s very little further that these rates can fall so should the Bank turn to buying other assets? Following this morning’s news that, while overall lending to businesses under the Project Merlin plan hit target, lending to small businesses missed by a fair margin calls that more must be done have increased.

SMEs make up the lifeblood of the UK economy and the fact that 30% of them “missed out on a growth opportunity” because of a lack of funding last year, according to the Federation of Small Businesses, confirms that growth is here but it must be fostered. If this malaise continues through until May, when the latest QE injection will run out, then it may be time for Mervyn to spread the wealth.

Trade of the Week

This week’s trade of the week is a very popular option as it gives you a strike rate well above current market and is called a Knock Out Double Cap. This particular trade was for a client who imports goods from China and was looking to get a rate that would be unobtainable elsewhere to boost his average covered rate for the next 6 months. The below example is therefore in GBPUSD but the trade is available in other currency pairs.

The client received a strike rate of 1.6100 against a forward rate of 1.57 and is protected at this level as long as the GBPUSD has not traded below 1.5180 in the monthly window period. If it has then he loses his protection at 1.61 for that month. If the rate is between 1.5180 and 1.6100 then he receives 1.6100. If the rate is above 1.6100 on expiry then he must buy double the amount of dollars at 1.6100 i.e. if he was originally hedged for USD150k then he must buy 300k.

This structure has proved popular for 2 reasons. Firstly it allows the client to obtain a strike 4 cents above current forward market and secondly, with markets range-bound at the moment provides a balanced risk/reward as part of a hedging portfolio. As such we would recommend that this trade is taken alongside a structure that provides a concrete worst case rate.