Quantitative Easing and LDI have a lot in common - more than you might think

August has been a volatile month for long dated gilt yields, having risen sharply by 0.4% in the space of a week to reach close to their highs of last October before falling back equally sharply. This reminds us that holders of UK gilts continue to experience significant fluctuations in their investment’s value. Along with pension schemes’ holdings, the QE program has resulted in a substantial investment in gilts and the implications of this are a little closer to home than some may have realised.

As a quick reminder, QE is now a firmly established tool of central bank policy in pursuing a moderate inflation target. The Bank of England (BoE) target for CPI inflation is 2% because moderate inflation is good as it encourages us to spend or invest the cash in our pockets today, rather than waiting until tomorrow. Deflation has the opposite effect and is the economic equivalent of stalling a car - everything grinds to a halt. Deflation was a pressing concern following the 2008 global financial crisis and QE was like pulling out the choke, letting more fuel flow when all things economic were running a bit cold. First used in Japan in 2001 and adopted in the UK in 2009, and widely across many developed economies, QE is a way of stimulating economic activity when the primary banker’s tool of reducing short term interest rates has been maxed out, or more accurately bottomed out - near zero.

UK QE involves two steps:

• New money is created by the BoE 
• That money is loaned to the Asset Purchase Fund (APF) to buy a portfolio of assets

An obvious question is why is the second stage necessary? An alternative would be to simply spend the printed money on government services - i.e., combine it with fiscal stimulus. This would boost the economy but you’ll never see that money again so you can never unwind it. Any inflation impact would be permanent - the inflation cat would be out of the bag. 

The solution to this is to invest it, not spend it. That way, when the program has done its job of shoring up the economy, you can sell all the assets back, pay off the loan, and cancel the printed money and interest. It would be like QE never happened, apart from all the good that it did when the going was tough.

Next question is where to invest? You could invest in the stock market, but you could bet on the wrong stock and lose a lot of money - somewhat frowned upon in central banking circles I suspect. Instead, you can buy government debt, which should ensure you get the money back but still helps pump the newly printed cash into the economy.

A small wrinkle is that because the money is loaned to the APF with an interest rate set at the Bank Rate, if the returns on the assets over the holding period aren’t enough to cover the interest cost, there might be a loss incurred. This might sound unlikely with government bonds but actually it is extremely likely. If you buy a fixed interest bond, the yield you receive is the market’s current expectation of future interest rates. The odds that actual interest rates turn out higher than expected is loosely speaking 50%.  Add to this the practical reality that QE involves buying low risk assets when they are highly prized (i.e. expensive) and selling them back when the economy is stronger and less risk averse (i.e. cheaper), the likelihood of QE making a loss is increased further. 

This was foreseen and HM Treasury agreed to indemnify the Bank of England for any losses, in exchange for receiving any profits and positive cashflows on the program. Through this, up until 2022, due to exceptionally low short term interest rates, QE has delivered a relatively consistent source of extra funding to the Treasury through profits and positive cashflows on assets purchased, totalling £124bn between 2013 and September 2022. However the sharp and sustained rise in rates witnessed since early 2022 has offset those gains and resulted in projected net losses from QE up until 2033 totalling £150bn as reported by the FT in July. This is only a projected cost, and the actual cost will depend on what happens to actual interest rates from here. When assets mature, or are sold as part of the unwinding of QE, (i.e. Quantitative Tightening), any realised loss is accounted for and the Treasury is invoiced on a quarterly basis. This expected payment from HM Treasury to the APF is expected to be £40bn for each of the next 3 years.

So put simply, the UK government will make a profit on the QE program if actual short term interest rates are lower than the yield on the long dated bonds that were purchased. Conversely they will make a loss if short term interest rates turn out to be higher than the yield on the bonds. This is starting to sound a lot like something else - leveraged Liability Driven Investment (LDI). Pension schemes experience the exact same profit and loss from leveraged LDI as the UK government does from QE. A big difference though is that pension schemes are hedging liabilities which move in the opposite direction.

So what does this all mean?

Contrary to popular belief QE is not pure monetary policy. It potentially involves government funding, and given how interest rates have risen and that QE is now being unwound, it is expected to amount to a real cost that will involve real tax payer’s money to pay for. This cost is no different to any other government spending. We need to remember this was always a likely outcome recognised by government and the BoE, and that when assessing value for money, any cost will need to be weighed up against the economic benefit of the stimulus. This assessment should also reflect other factors such as reduced borrowing costs that the government has benefitted from as a result of QE. In short, we need to look at both sides of the equation. An issue is that many people didn’t realise there might be a cost side to the equation at all.

So on closer inspection QE and LDI have a lot in common. Both profit when interest rates fall, and make losses when interest rates rise. However whilst many thought that pension schemes have lost out as their portfolio values have fallen as a result of gilt yield rises, in truth rising rates have been great for defined benefit pensions overall. Their financial position has improved by around £400bn since the start of 2022. On the flip side however, as a result of QE, rising interest rates have imparted a substantial cost on the UK tax payer, at £150bn, crudely speaking, it’s currently projected to cost more than HS2.