How is the Bank of England's "quantitative easing" initiative progressing?

The Bank is on course to achieve its target of buying £75 billion of assets by early June. As of yesterday (16 April), cumulative purchases had reached £34.3 billion, comprising £31.5 billion of gilts, £0.5 billion of corporate bonds and £2.4 billion of commercial paper – see first chart.

The dominance of gilt-buying has led to criticisms that the Bank is failing to achieve its objective of improving the flow of finance to companies. This is simplistic, ignoring the indirect benefit of institutions that have received cash from the Bank in return for gilts reinvesting the proceeds in corporate securities.

Another criticism is that corporate yields are little changed from their level when the asset purchase facility was first announced in late January. However, stability in the investment-grade index conceals a material fall in yields on securities issued by non-financial companies offset by a rise in financial yields – second chart.

In any case, the impact of the scheme on credit conditions cannot be measured simply by yields – improving companies' ability to raise funds is a more important goal. Encouragingly, underwritten sterling bond issues have totalled £54 billion so far in 2009 versus £94 billion in all of 2008, according to Bloomberg.

The success of QE will ultimately hinge on its impact on monetary growth – particularly broad money. As expected, unsterilised asset purchases have boosted banks' reserves at the Bank of England, which – together with currency in circulation – comprise the monetary base. Annual growth in monetary base has soared to 66%, well above levels in the Eurozone and Japan though lower than in the US – third chart.

March broad money figures will be published next Wednesday but – as previously discussed – headline M4 has been distorted by the activities of "intermediate other financial corporations". The Bank of England is unwilling to publish monthly estimates of its adjusted M4 measure, excluding money holdings of these entities. The last quarterly number, for December, showed annual growth of just 3.8%; the next Inflation Report, due on 13 May, should include a chart incorporating a March figure.

Annual growth in adjusted M4 probably needs to rise to 10% to lay the foundations for an economic recovery. The Bank's asset-buying plans appear to be on the right scale – £75 billion is equivalent to 4.5% of adjusted M4 so a one-for-one impact, assuming a stable underlying trend, would imply a rise in annual growth to 8-9%.

There are two risks. First, to the extent that the Bank buys securities from banks and overseas investors, rather than domestic non-banks, there is no direct positive impact on M4. The Bank will publish March data on gilt transactions by non-banks, banks and overseas investors on 1 May. These are, however, net figures, including purchases of new issues from the Debt Management Office.

Secondly, the boost to M4 from QE could be offset by a further slowdown in private sector lending growth, reflecting weak credit demand and / or continuing efforts by banks – particularly foreign-owned institutions – to shrink balance sheets. Continued sluggish M4 growth would indicate not that QE has failed but rather that plans need to be expanded to utilise more of the £150 billion authority granted by the Treasury.

Recent evidence of a liquidity thaw and easing credit conditions suggests that the probability of a V-shaped global economic recovery is rising.

Consistent with a normalisation of money flows, the spread between UK interbank and government interest rates has narrowed to its lowest level since Lehman's bankruptcy last September – first chart.

An equivalent US measure, inverted, is shown in the second chart along with the annual growth rate of US industrial output. Historically, recessions have been signalled by the spread moving above 100 basis points. It reached a peak of 360 bp (monthly average basis) in October but is now back below 100 bp, supporting recovery hopes.

Business surveys are recovering, with yesterday's New York Fed survey notably stronger. This improvement was foreshadowed by a slowdown in earnings downgrades by equity analysts – third chart. Assuming that the recovery in the "revisions ratio" survives the current earnings reporting season, purchasing managers' manufacturing indices look set to revert to the breakeven 50 level, implying a stabilisation of industrial activity.

A previous post suggested a more promising outlook for corporate high-yield bonds, based on an easing of credit conditions reported in the latest UK loan officer survey and the likelihood of a similar improvement in the next US survey, due for release in early May.

Another hopeful sign for credit conditions and high-yield bonds is a recent fall in the borrowing requirement of US non-financial corporations, defined here as their “financing gap” – capital spending minus domestic retained profits – plus share purchases net of issuance. As the chart shows, this measure leads the yield spread of high-yield bonds over Treasuries.

The borrowing requirement has fallen steeply from 9.5% of GDP in the fourth quarter of 2007 to 3.6% by last year’s fourth quarter. A further decline is likely, since companies’ net share-buying was still running at 3.2% of GDP in the fourth quarter but should slow in 2009.

A sharp fall in the borrowing requirement preceded a narrowing of high-yield spreads by two years in both the late 1980s and early 2000s. Assuming a similar lag in the current cycle, high-yield spreads could decline significantly from late 2009.