Equity Vs. Bonds: The Liquidity Trap in The Uk

Equity vs. Bonds: the Liquidity trap in the UK

"Know what you own, and know why you own it."

Peter Lynch

Introduction

In the last decade, there has again sparked an interest over the term “Liquidity trap”. Many countries after the financial crisis in 2008 seem to be experiencing of this phenomenon and may consequence of it for longer period. The liquidity trap is happened when central bank’s monetary policy become ineffective and the nominal interest rates are close to zero and are not able to reduce more.  That has leaded investors to rethink a position regarding capitalising into free risk market and switching to equity market. In other words, bonds are experiencing exceptionally low yields and investors expect that interest rate may go up which would result of a capital loss (Congdon, 2012).    

The economical view before the financial crisis considered monetary policy as stabilisation instrument. However, recent simulations using money supply caused zero lower bond interest rates which define the liquidity trap, and these actions had minor impact on macroeconomic performance (Rezende, 2011). According to Weinberg (2013), the reason why the UK is in the liquidity trap is not only related to low interest rate, but also he stated that investors became more risk aversion with their money and preferred to hold cash rather to invest in risky assets. On other hand, the banks decreased lending when interest rates became low and people favoured to hold cash. All consequences taken in account resulted decline in financial market, especially it is observed with fixed-rate bonds.

In order to counter liquidity problem and boost economy, the Bank of England introduced bonds purchase programs that called Quantative Easing (QE) since classic monetary tool became vain and interest rates was already close to zero . The UK monetary authorities applied Quantative Easing by purchasing gilts without reference to interest rates from financial institutions and private companies to allow use money to lend and buy back more bonds from the central bank. This tool has effect of depressing interest yields on government gilts that offers it cheaper for investors to raise capital (Bank of England, 2010). However, on the one hand it leaded improvement of economy, but on the other hand it created situation when investors preferred to switch from gilts to other investments such as equity in order to get more returns (source). The liquidity trap and the financial crisis had influenced not only on bond market, its consequences resulted sharp drop in equity prices. However, Davies (2012) stated that it may still better to hold equities if we consider returns based on inflation adjusted terms.  

The broad objective of this study is to identify position of UK assets market after financial crisis in 2008 in order to determine which kind of security looks more favourable for investors in the UK market. This paper will attempt to achieve this objective by applying of Equity Risk Premium (ERP) approach in order to estimate historical data on FTSE100 index and different maturity UK government gilts. Based on this objective, formulated hypothesis as follow:

 Equity’s return and risk are more attractive for investing rather than investment into bond market. 

H0: ERP is positive

H1: ERP is negative

Equity Premium Risk is a significant component of every risk and return model in investment evaluation and identify fundamental aspects how investors allocate their wealth in which specific assets (Damodaran, 2011). There are three method of calculating of ERP, but this study implement approach based on historical time series analysis to identify arithmetic and geometric mean and how EPR distributed. The ERP will be estimated as excess return from FTSE100 equity over short term and long term maturity UK Treasury Gilt to compare the outcomes for each.      

2. Literature Review

In order to answer research questions of the paper, this section will examine works of writers on this problem statement that dealing with position of the securities’ market in the liquidity trap. Moreover, this part will also be focused on theoretical and empirical studies relating the Equity Premium Risk approach.      

2.1 UK asset market position in the liquidity trap: Equity and Bonds

The financial crisis began in middle of 2007 that brought financial system to recession in many countries.  One of the key effects in the financial sector of the UK was contraction in providing of loan to the private sector that leaded to fall in output and growth of unemployment rate. The Bank of England implemented strategy by reducing the interest rates in the 3rd quarter of 2007. Historical changes of the interest rates can be seen in figure 1. Nevertheless, by early 2009 the conventional monetary policy became unsuccessful as rates were close to zero and it could not be reduced further. This had led to the phenomenon of the Liquidity Trap.        

[pic 1]

Figure 1: UK interest rates (TRADINGECONOMICS, 2014)

Consequently, as the central bank introduced low interest rates, the prices of government bonds rose and yields were down. The liquidity trap influenced badly on equity market in the same time as well. The performance of stocks experienced collateral damage through several reasons such as liquidity problems, market depth and sectorial concentrations. However, according to Davies (2012), he stated that the return in nominal terms is low, but it seems better to have equity in inflation adjusted terms.    

The bank of England introduced alternative way to stimulate growth by injecting money directly into economy that is known as quantative easing. It is not just printing money, it making money electronically to buy government gilts from financial institution and firms. According to Bank of England (2010) that the main aim of this instrument is encourage money circulation between all parties by affording an opportunity for banks to use the money in order to increase lending and/or buy different asset and bonds, which in the end it is resulted more wealth in the wider economy.

However, despite of low interest rate, the quantative easing had major impact on UK gilt market in terms of its return. Harris (2011) explained that there are number of reason why UK fixed income securities are currently experiencing low yield. He stated that quantative easing programme was used to buy the bonds irrespective of price that distorted the market and made gilt prices higher and returns lower. The another cause of low yield is that interest rates low and investors think that rate soon will rise that encourage capital losses as prices decline. Furthermore, empirical study of Professors Martin and Milas (2012) demonstrates that reduced interest rate by quantative easing might increase finance cheaply for corporates, but the facts show that it has not caused the growth of investment by these companies.