EZ QE – The Tyranny of expectations

I have a trade for you, but you have to read some economics. For those not interested in markets, read up to the bit where I start going on about trades…

The Eurozone’s central banks are currently purchasing around EUR 60bio of debt securities per month using newly created reserves. When the policy was announced on the 22nd of January, the chairman of the ECB told us that:

“They are intended to be carried out until end-September 2016 and will in any case be conducted until we see a sustained adjustment in the path of inflation,”

Now, let’s first clarify what’s important here. People get very hung up on this idea that it’s a big deal that all this ‘new money is being created’ – but it isn’t. All that’s happening is that one type of asset, government bonds etc, is being removed from the economy, and substituted for another, central bank reserves. The ECB does not subscribe to the quantity theory of money, it is not trying to create an excess  of cash, because growth in base money is not a determinant of inflation or output. Rather, it seeks to do two things:

1. Lower long term interest rates, and therefore real interest rates. All things being equal this should discourage financial saving.

2. Force portfolio rebalancing by removing the option to own government bonds. All things being equal, investors will therefore be forced to allocate to equities and ‘real’ assets (infrastructure, property etc)

Number 1 is a shot in the arm for consumption. Number 2 should do the same for investment. Output will increase, and if No. 2 is not big enough to absorb the increased spending from Number 1, so should inflation. So far so neat.

And it actually seems to be working! Having played a large part in my disastrous paper portfolio performance this month (update to come), long term interest rates in the Eurozone are low. Very low. 30y rates are at 0.85%. The current cheapest to deliver bond for the Bund future is 9y long and yields 0.08%. If you look at what the market is implying for 2y2y real interest rates (Nominal rates – inflation) – it’s looking good. They actually managed to get them down – to -1% no less!

EUR 2y2y Real

And Europeans have responded, credit growth (which pretty much represents financial saving) is back to flat.


Haters like to say that the big problem with the zero lower bound on nominal interest rates is that you can’t push rates negative when you need to – but the ECB have done it. -1% in real rates (admittedly mr Bernanke says in that post that the practical lower bound on interest rates is -2% if the CB has a 2% inflation target!).

My awful premonition however, and I’m not a competent enough economist to fully justify it so you’ll have to trust me on it, is that this success in lowering real rate expectations will sow the seeds for QE’s failure. Think about what’s happening to agents in an economy with really low real rates as time passes. If the inflation actually materialises, happy days, expected and realised real interest rates are in line so investment and saving decisions are proved correct. Trouble is, we’re a million miles from this world – just look at CPI!

CPI!With forward real rates being so low compared to realised real rates, the mechanism by which monetary loosening is supposed to effect the economy – by encouraging investment and consumption over saving – is being undermined. We’re in a trap where real rates realising higher than expectations eventually kills inflation expectations themselves! Monetary policy is supposed to be able to muscle through this by just cutting nominal rates until spot real rates are meeting expectations – and economic actors respond. But where are interest rates in the Eurozone? oh.

This is the issue with the zero lower bound. It doesn’t matter how much QE you promise. You can’t make REALISED real interest rates low enough to satisfy the expectations of economic actors – and they’re going to end up doing what economic actors who face unexpectedly high real rates of interest do: save. Output and inflation aren’t going anywhere in this scenario. That’s the tyranny of expectations. You have to meet them.


Everyone is long European equity right now. They’re doing this because of the portfolio effects of QE, and the declining expected real rate making them look attractive on a valuation perspective. For those people – I have a ‘can’t lose trade’. Short inflation protected bonds. Real yields on 8y German inflation protected government bonds are -1.2%. As 8y bonds are around 0, that means inflation has to realise at 1.2% on average for the bonds to be worth the protection (explanation of how linkers work below!). It’s currently realising at 0.

If inflation goes up, well good for you! QE worked, we broke out of the expectations deathtrap, and we can get back to something like business as usual. You made a tonne of money being long European Equities. Shame you lost money following my recommendation huh. OH WAIT no you didn’t! If inflation gets back to the ECB’s target level, sure you’re going to get hurt on the inflation bit of your bond trade – but remember – it’s still a bond! Being short it makes you money if rates are going up. And are rates going up in the Eurozone if inflation picks up, with the ECB as  a single mandate central bank targeting inflation? Seems a fair bet.

However, if inflation doesn’t go up, your equity position could be in real trouble. In that scenario, real rates are realising higher than people expected, output and inflation are therefore likely to fall further – not good for those companies you own. Plus, you thought they looked attractive when you valued all those future dividends at real rates of -1% – but real rates aren’t 1% no! People are going to prefer cash or bonds in a world like that – and you’re going to get slammed – unless you followed a friendly stranger on the internet’s advice and went short inflation protected german government bonds.

PS: How Linkers work – Inflation protected securities are issued by many governments. Regular bonds have fixed coupons – they pay you a fixed amount (say, 2% of the amount you invested) every year. So whatever happens to inflation, you’re going to get the same yield. However – if you’re investing for your pension you might not be so happy about that. Inflation reduces your ability to buy stuff with the cashflows from your bonds. Inflation bonds save you the worry. When you buy an inflation bond, every cashflow gets uplifted by whatever inflation turns out to be. The coupon that you end up getting each year therefore depends on inflation – you get more each year if inflation is higher. The UK, US, France, Germany and Italy all issue them. Spain just started and has only two so far.

PPS:  Not that anyone cares, but I’m not doing this for my paper book. My paper book is a fixed income opportunity book, not a macro opportunity book.


4 thoughts on “EZ QE – The Tyranny of expectations

  1. Limehouse says:

    Hi, really interesting post. When short this bond I assume you’d have to pay the annual indexed 0.1% coupon which you wouldn’t expect to be significantly costly over the life of the trade; however shorting this bond, aren’t you implicitly taking a view on path of interest rates, the HICP print and German credit risk?

    I suppose if perceived German riskiness increases, that’s good for you given you’re short the bond?

    I don’t know how easy/practical it is to short these types of bond, but what would be the disadvantages of entering into a swap; paying HICP and receiving floating EURIBOR?

    • Hi, no being short doesn’t mean you have to pay the coupon – the German government will take care of that!

      Yes you do have all of those positions. You’re short German credit, short interest rates, and short HICP.

      Pretty practical if you’re an institution. Don’t do this (or in fact anything I say!) With your own money! Do it with someone else’s, preferably a rich persons

  2. Ignorant says:

    “Don’t do this (or in fact anything I say!) With your own money! Do it with someone else’s, preferably a rich persons”

    How would you suggest someone without our own institution or handy rich person do this? Invest in the stock of a fund running this trade?

    • Honestly, if you’re an average person such as me, this macro game is not for us to play. It’s insanely risky, it’s so easy to make an error that costs you everything – stick to trackers and if you have a hunger for it – come work in the field and play the game.

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