How Quantitative Easing Works and Why Do It Now
Published / Last Updated on 06/11/2020
Governments borrow money by issuing government bonds or in the UK they are known as Gilts (gilt edged security Treasury Stock). They usually issue these in the form of fixed rate bonds or index linked bonds. In the UK, as an example, you buy a £100 Treasury Gilt 2030 paying 1% pa. You receive £1 per year (it’s actually £0.50 paid in January and £0.50 paid in July) for 10 years as a coupon/interest and in 2030 you get your £100 nominal face value repaid.
In the UK, government bonds (i.e. borrowing more money) is handled by the UK DMO (Debt Management Office) and usually each week an ‘auction’ takes place i.e. the government borrows more money as government debt bonds (Gilts) are sold. In fact at this week’s auction:
- On 04-Nov-2020 a 1/8% Treasury Stock 2026 (repayment date), raised £3bn
- On 03-Nov-2020 a 1/8% Treasury Stock 2028, raised £3.4bn
- On 03-Nov-2020 a 1¼% Treasury Stock 2041, raised £2.5bn
Rates are low but your investment is virtually guaranteed as it is backed by the British Government. That said, at the auction you sometimes pay more than the £100 nominal face value. The 2026 stock above reached an auction average bid price paid of £100.65 for a £100 face value gilt. Investors are prepared to pay more than the nominal value and accept low coupon/interest rates for security given the Bank of England looks likely to move interest rates negative.
Step In Quantitative Easing.
By way of a simplified example to illustrate the point, 20 years ago in July 2000, the Treasury issued an 8% Treasury Stock 2021. This means they have been paying £8 coupon/interest each year on every £100 Treasury Stock and will continue to do so until 2021 when they pay the final coupon and the nominal £100 face value. This is a simplified example but explains why they are currently using Quantitative Easing.
Quantitative Easing (QE) is where the Treasury buys back/pays back and closes old Treasury Stock held by banks, pension funds and investors to release more money back into the economy e.g. Banks then have more liquid cash to lend cheaply to businesses and consumers. In short, and it makes sense, the Treasury could buy back older Treasury Stock that it is currently paying say 4%, 5%, 8%, 9% pa on and borrow again the next day with new Treasury Stocks at a rate of just 1/8th % i.e. 0.125%pa. This is quantitative easing and why the Bank of England confirmed again this week a new round of QE at £150bn.
The government is technically locking in its debt at historically low rates in the same way that if you were on a mortgage rate of 5%pa and could lock into a fixed rate for 5 years or 10 years at 2%pa then you would consider this. The same for credit cards, if you have a credit card debt with an APR of 24%pa but for a switch fee of 3% you could do a balance transfer to a new card at 0%pa for 2 years then you most likely would.
In very simple terms, the debt has not gone away, we are massively in debt and the government is borrowing even more to fund the coronavirus pandemic and Brexit but at least it is refinancing its existing, more expensive debt e.g. the 8% 2021 Stock could be refinanced at just 0.125%pa.
