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QE, Bonds & Interest Rate

Updated: May 6, 2021

An interview transcript with Money FM 89.3 on 14 Jun 18:

Ryan: ECB is on course to begin QE Exit, it's making a lot of headlines - will it do it or not, before we get into that - let's start with the basics. How did it get to this stage and how exactly does all this bond-buying affect its economy?

It all started with US Wall Street melt-down triggered by US housing bubble in 2008. This created a domino effect worldwide and EU was not spared. To counter the situation, US started it’s QE programme around that period, As for EU, it's been difficult for the 19-nation euro area to do the same thing, partly because of different interpretations of European Union rules.So EU’s strategy then was to work on the interest rate, they have chosen to reduce their interest rate to minus zero over time.Situation did improve, but not good enough. In early 2015, 6 years after US started it’s QE programme, ECB also started their own QE programme. Today for the ECB to consider to scale back their QE programme, in my opinion, it means there may have some improvement in their economy.

Ryan: So the ECB started buying bonds back in January 2015. This was part of a move to start help stimulate the economy. Help us to walk through the basics from the ground up. When we talk about bond-buying, what exactly does that mean, what exactly is a bond, who is it buying from?

ECB or the Fed, they are central bank. Let me give you an example on US perspective. There are 2 main organisations, the US Treasury department and the US Fed. For US Treasury, part of their role is to raise fund by issuing bonds through auction. The money received is used to spend on public works – like building road, bridges and etc. The convention way for the US Treasury to raise money is to sell bonds to the banks, the institutions and the corporate. This means it is the banks, the institutions and the corporates investing into the US bonds or debts.Again, this should be the conventional way and in my opinion it is also a healthy sign where government bonds are been subscribed or invested by mostly the private organisations. Today we are seeing the unconventional, in 2008 when US started their QE programme.This means the US Fed or the ECB, these are central banks.Instead of private organisations, now it is the central banks are also buying into their national bonds from their Treasuries.

Ryan: How does buying bonds help the economy?

Bonds prices and interest rates move in the opposite direction. The focus or the priority should be on the direction of the interest rate, and not on the direction of the bond prices. A lower interest rate does stimulate the economy, it draws us to borrow more money to buy our dream house. For the businesses, it give them incentive to borrow to spend on machinery or to buy another factory to expand their business. At the moment the interest rates are creeping up, therefore we should be seeing a lower bonds prices.Interest rates up, a lower bond prices. If we work backwards, what will cause the interest rates to go higher?Ans: Inflation. If we work backwards again, what are the causes for a higher inflation in today’s market? Many will say it must be an overheating of economy, but I see it from another dimension. I am seeing a weakening of the currency, therefore causing a higher inflation in the US market. The US dollar since the beginning of 2017, has been depreciating about 15%.With a lower value in dollar, it means it will cost more today to buy the same product 2 years ago. And that is inflation. The matrix is, first find out what the causes of inflation. When inflation comes, there will be higher interest rate. With higher interest rate,Comes a lower bond prices.

Ryan: As yield or interest rate moves higher, why should the bonds be traded lower?

Let me give you an eg. on this. For a 10 years bond that I have invested, it promises me an annual interest of 2%, this 10 years bond itself has a price for me to invest in them, say it is priced at $100.This becomes the bond price. If I am interested to invest in this 10 years bonds, today I pay $100. 12 months later, on a yearly cycle for the next 10 years, I will received $2 as interest each year.10 years later, at the end of the tenure, I will received my principal amount $100. However, somewhere along the timeline. Interest rates went up suddenly, for whatever reason. A new issue 10 years bonds now pays a 4% interest rate. What will I do? I will sell my old 10 years bond, so as to re-invest into a new 10 years bond that pay me 4%. I would prefer to put my deposit that pays me a higher interest rate. But for me to sell that old 10 years bond, that may depress that bond prices, that was priced at $100 previously. Just think in term of a $100 stock that pays you a dividend of $2. If you would like to switch-out to another stock that pays a dividend of $4. Since many investors are also switching-out, surely, the $100 stock will be trading lower.

Ryan: How does this affect other assets in terms of their prices and yields?

Once the benchmark like the US Fed rate or the ECB rate started to moves higher. To attract investors to put their deposit as a loan, both the corporate and government bonds have to also up their game, to offer a higher interest rate. It is a competition among each other to get the extra working capital.

Ryan: Let's recap why the ECB had to do it - what was the shape of the EU economy, how bad was it. The ECB actually cut its bond buying program by half earlier this year in January from 60B to 30B, but extend the length of time that the program runs. Where are we today, why are a lot of people saying that perhaps now is the time for ECB to stop buying bonds - are there indicators supporting this?

For central bank like ECB, acting as an investor to buy it’s own government bonds, it is not conventional, but yet it is a necessary measures in time as such. However it cannot be sustained in this type of arrangement perpetually, it is not a healthy way to grow an economy. To make adjustment along the way, it is definitely the right thing to do. US has stop their QE3 programme in the middle of 2014.What are they focusing on now? Trades has to be in their favour. The bottom line is to bring in more income, focusing more on manufacturing, exports and etc.

Ryan: Are you seeing this almost 4 decades of downtrend has ended?

According to the technical studies, it seems like that is the case. Furthermore, the fundamental development in the recent years also match-up with this view.

Of course there is always opportunity in any given situation. For the time being, I still prefer to stay cautious and continue to look-out for the laggards and the defensive stocks.

Ryan: How well has QE worked in the past and what are the risks?

The birth of QE started in 2008, 10 years in history, it is too short.And it is also too early to tell if QE really works!It did stabilised somewhat during the 2008 crisis, but has it provided us a platform for steady growth moving forward? Both individuals and policy makers have to keep watch and keep adjusting along the way.

Ryan: What will be the potential scenarios for the markets and EUR, based on the decision by ECB?

The ECB is expected to maintain that it will leave interest rates at the current level.It is unclear whether the ECB will announce a taper at this meeting or next — we simply cannot know. I will prefer to also take clues from US and focus more on the longer term time frame. It seems to me US interest rates should continue to trend higher in the coming years. If this happens, ECB would likely to follow and adjust their interest rate higher as well.

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