QE and bonds economics

bobhopeful

Can any kind and informed MSE member help with this question?
When central banks want to increase money supply QE is an option. It is often explained follows:
The central bank creates more money. It does not give the money straight to the banks. The banks hold Government bonds (as a secure and liquid alternative to holding their mandatory capital reserve requirements in just cash). The central bank uses the QE cash to buy these bonds from the banks.
Question: banks could theoretically have sold their bonds on the open market at any time, but were choosing to hold them, so when the central bank offers to buy their bonds, why do the banks now want to sell?

Thrugelmir

Who would they have sold them to though?

Banks needed to increase liquidity. Hence the desire to sell.

One aim of QE was to provide the entire financial system with stability.

Reaper

bobhopeful wrote: »

Question: banks could theoretically have sold their bonds on the open market at any time, but were choosing to hold them, so when the central bank offers to buy their bonds, why do the banks now want to sell?

They could sell them on the open market but during the crisis nobody had spare cash to buy them. Plus the Bank of England was willing to pay more for them.

The purchases drove the price up which meant the yields went down. So in theory the companies selling had no incentive to replace them with more bonds, instead doing wealth generating activities such as lending the money out or buying shares.

It's also inflationary which in this case was considered a good thing because deflation can be damaging.

That's the theory anyway. How well it works in practice is another question.

bobhopeful

Thanks for the replies Thrugelmir and Reaper.

You both suggest that one reason for selling to the CB is that "who else?" because the bonds would not have been saleable on the open market. But why not? Surely in times of stress stocks are sold and bonds are in more demand?

Also I understand the yield goes down as price goes up. But doesn't the ROI on bonds already held remain unchanged (return on the original price paid). So if the bank paid 100p per bond held and the coupon was paying 3p then annual ROI is 3%. Now if the bond price increases to 200p the yield for current buyers is 1.5%, but the bank paid 100p so if it holds its bonds it still gets 3% on its original investment. So why sell?

Also bond prices are increasing due to CB hoovering them up, so what if the banks decide to hold in a rising market to make more gains. Is it simply that banks make more from lending and investing in bonds is not core business but just a legislative requirement?

seacaitch

QE is essentially an asset swap, whereby the central bank acquires the private sector's assets (generally long term gov bonds) in return for cash (via newly created central bank reserves).

Why would the private sector sell its long term gov bonds in return for cash? Profit, obviously. Because of the higher prices generated by the central bank demand.

The central bank is a price insensitive buyer whose actions thereby drive up the price of the assets they're seeking to buy, and higher prices always eventually brings out sellers. Even if no one sold, the price would still be driven up, because the central bank would be sat there willing to buy any assets offered for sale.

Reaper

bobhopeful wrote: »

You both suggest that one reason for selling to the CB is that "who else?" because the bonds would not have been saleable on the open market. But why not? Surely in times of stress stocks are sold and bonds are in more demand?

The price matters little if nobody has the cash available to buy, and at the height of the crisis there was a liquidity crunch. The Bank of England dropped interest rates as low as practical but even that was not enough so QE was tried to remove unhelpful government bonds and replace them with liquid cash.

bobhopeful wrote: »

Also I understand the yield goes down as price goes up. But doesn't the ROI on bonds already held remain unchanged (return on the original price paid). So if the bank paid 100p per bond held and the coupon was paying 3p then annual ROI is 3%. Now if the bond price increases to 200p the yield for current buyers is 1.5%, but the bank paid 100p so if it holds its bonds it still gets 3% on its original investment. So why sell?

You are right the coupon paid in cash terms remains the same but there is an opportunity cost in not selling. If they sold that bond in your example they could make a 100% profit on the purchase price and look round for something better to invest it in. It may be getting 3% on its original investment but it is only getting 1.5% on its current value. If they can find something paying better than that then they should switch.

bobhopeful wrote: »

Also bond prices are increasing due to CB hoovering them up, so what if the banks decide to hold in a rising market to make more gains. Is it simply that banks make more from lending and investing in bonds is not core business but just a legislative requirement?

Ah now we are moving from theory into practice. You have to remember most of the bonds the Bank of England bought were from pension and insurance funds. The banks were not involved and they DID think it was a good idea to speculate by buying bonds with whatever spare cash they had which somewhat defeated the purpose.

Worse the pension and insurance companies were not always keen to sell for the same reason. The yields might be poor but if you know there is a buyer out there with bottomless pockets it is tempting to hold out for a higher price.
eg Bank of England struggles to buy enough bonds

bobhopeful

"The price matters little if nobody has the cash available to buy, and at the height of the crisis there was a liquidity crunch."

In times of stress with stock markets falling, private and institutional investors will have sold equity holdings and may be sitting on piles of cash and/or want to increase bond holdings. Or is this not the case?

Not being argumenative here BTW, just interested in understanding how CB use QE with the banks.

So at its simplest I can see that banks prefer to lend money for profit than hold bonds so they sell to the CB.

Sp does QE always come in tandem with the banks being allowed to lower the amount of capital reserves they are required to hold, because these reserves will at least in part comprise the bonds they are selling? But if so isn't lowering reserve requirements risky just when banks need adequate reserves to cover bad debt risk which is higher in a downturn?

seacaitch

You keep focusing on banks when, as has been pointed out, the originating sellers of the assets bought the central bank will in the main be other private sector actors.

Also, you seem to be considering QE as a short-term tactical tool to reduce immediate market stress when the reality is it's been deployed as a longer-term strategic tool. Any short term impacts will likely be largely as a result of changing future expectations rather than immediate effects on present conditions.

The question about "sitting on piles of cash" is not really relevant. When someone sells an asset, someone else buys it. The asset seller now owns the cash and the asset buyer owns the asset; all that's changed is who owns what and the price of the asset (reflected the relative preferences of parties to own cash or assets).

short_butt_sweet

there are 2 separate questions: why are bond holders prepared to sell them to the CB for cash? and how (if at all) does this lead to more bank lending?

it's not a single question, of do the banks prefer to be lending to the government (by holding gilts) or to businesses/speculators?

partly because the sellers of bonds may not be the banks. (the banks may act as intermediaries, i.e. buy gilts from their current owners in order to sell them on to the CB.)

a new buyer in the gilts market (the CB) will simply push up the price of gilts, until enough holders are enticed to sell to match the demand from the new buyer. so somebody (bank or not) ends up holding a different mix of assets, viz. more cash and less bonds.

does this encourage banks to lend more to businesses? not necessarily, at all. but it might do, a little bit. why?

there are several factors limiting how much banks lend at any 1 time.

one is that they are probably required (by the CB) to hold some minimum amount of reserves / safe assets relative to the amount of risky lending they've made. however, both reserves at the CB and gilts are regarded as safe assets, so it doesn't make any difference that a bank may (if they are who sold gilts to the CB) now hold more reserves and less gilts.

another is that there are willing borrowers. perhaps there will be more willing borrowers now, because QE reduces longer-term interest rates (by raising the price of bonds). this only works if the bank lending is made at rates linked to longer-term bond yields, not to the current bank base rate; and if the banks pass on the reduced bond yields in their lending rates. and if it makes any difference to borrowers' willingness to borrow. which it may not, since the interest rate they'd pay is only one factor for them. and a reduction in interest rate of (say) 1% may not be very significant if a bank is lending at (say) 10% above what a safe bond is yielding. however, it is possible that there are a few more willing borrowers.

another factor is that the bank consider the borrowers credit worthy. again, if they will be charging the borrowers slightly lower interest rates, that makes it a bit less likely for the borrowers to be unable to pay the interest, so they may consider potential borrowers slightly more creditworthy.

so there are lots of questions about whether or not banks will lend (noticeably) more as a result of QE. but it's separate from the reasons why banks (or somebody else) is prepared to sell their bonds to the CB.

Thrugelmir

bobhopeful wrote: »

But why not? Surely in times of stress stocks are sold and bonds are in more demand?

To put matters into perspective. The BOE has bought £435 billion of gilts and corporate bonds.

Net contributions into UK pension schemes are around £2 billion a month.

The largest company quoted on the London Exchange is Shell at £235 billion.

In the year of the GFC 2008/09. HMRC raised total taxation receipts of £445 billion.

seacaitch

The OP, bob, is struggling here somewhat because his basic premise - that QE is primarily intended to boost lending into the economy by banks (using 'cash' they've obtained by selling gov bonds to the central bank) - is wrong.

Central banks have control of short term (overnight) interest rates; QE is designed to give them a level of control over longer term interest rates, thereby affecting rates (yields) over the entire term structure.

Lowering longer term rates lowers the discount rate used to value the cash flows generated by assets, thereby increasing the price of those assets. Increased asset prices makes people feel wealthier and, in theory, spend more (in practice, wealthy asset owners don't tend to become much more spendy when they feel wealthier, unlike poorer people who do become spendy - a key criticism of the efficacy of QE as a policy...).

But in theory (and in practice to some degree), higher asset prices, generating a so-called wealth effect, raises confidence and may cause people to generate more economic activity: people consuming more stuff or individuals or businesses embarking on investment projects, all of this facilitated or made viable by interest rates that are lower - across all borrowing timeframes - than they would have been without QE.

So, in this way QE may lead to additional lending by banks, but only as a secondary or tertiary effect of QE, not a primary effect.

In particular, any additional lending so arising will not be because a bank has itself sold a gov bond to the central bank and thereby gained cash which it could now lend, which I think was the basic premise that bob was working from.

[NB As I understand it, the BoE's FLS (Funding for Lending Scheme) was a policy intended to directly influence lending by banks into the economy. So bob may be interested in that]

A further effect of QE, in addition to the points above, was to improve the viability of government finances. By reducing longer term gov bond yields (due to higher bond prices), new bond issuance (or rollover of existing maturing bonds) by governments could be done at lower interest rates, reducing the interest rate burden on the government.

Additionally, in the UK and US at least, the interest (coupons) that the respective governments were paying to their own central banks on the gov bonds bought and held by them via QE, were then returned by the central banks to the governments' own Treasuries. In effect, this is turning those bonds held by the central bank into interest free loans to the government, generating a very significant further reduction in the interest burden of govt debt. I seem to recall the BoE holding ~30% of gilts, so this is a lot of debt not to be paying interest on.

I think this is where QE is getting nearer to so-called monetary financing of government, where the central bank just "prints" whatever the government wants, a gold-bugs wet dream. The key for govts and central banks seems to be maintaining credibility and confidence that this unconventional QE action is all temporary, and that the asset purchases will all eventually be reversed, and normal service resumed, so we can all look-through these unconventional measures and not get too jittery about it.