Author: admin

The ECB has been at pains to distinguish its securities markets programme (SMP) from US- and UK-style quantitative easing (QE). The differences, in practice, look minor.

Bond buying to date has been on a larger scale than suggested by the stated objective of restoring depth and liquidity to dysfunctional markets. €26.5 billion of securities were purchased in the first seven days (assuming T+3 settlement), equivalent to a weekly rate of €18.9 billion. If this pace were sustained for three months, the ECB would acquire a portfolio of €246 billion, equivalent to 2.6% of Eurozone broad money, M3, and 33% of the outstanding government debt of Greece, Ireland, Portugal and Spain (15% if Italy is also included).

The ECB claims that the SMP will have no impact on monetary conditions because buying will be sterilised. This is oversimplistic. A purchase of bonds from a non-bank investor results in an increase in both the investor’s bank account balance, included in the broad money supply, M3, and bank reserves, a component of the monetary base. If the ECB sterilises the purchase by conducting a reserves-draining operation with the banking system, the rise in the monetary base is reversed but not that of M3. (The M3 increase is reversed only if sterilisation involves a sale of assets to the non-bank private sector. Note that M3 is unaffected if the initial purchase is from a bank rather than non-bank.)

While the ECB is sterilising its bond purchases, moreover, it has reverted to supplying unlimited funds in its three- and six-month lending to the banks, in addition to the main one-week repo operation. The monetary base, therefore, is being determined by banks’ demand for ECB credit, which has increased as weaker institutions have suffered funding shortfalls. Accordingly, the base has risen by 3.8% in the first two weeks of the SMP and is up by 7.4% since late April.

The ECB’s method of sterilisation – auctioning one-week deposits to banks with surplus liquidity – is, in any case, cosmetic. Banks are likely to regard these deposits as a close substitute for reserves. The effectiveness of sterilisation may depend on the length of time reserves are removed from the system, with permanent asset sales having the largest impact.

The SMP, so far at least, appears to pass the QE “duck test”. Opposition from Bundesbankers and their ECB allies, however, could yet derail the programme.

As expected, GDP growth in the first quarter was revised up from 0.2% to 0.3%. More importantly, the profile of output over the three months implies a strong starting base for the second quarter.

The chart shows quarterly GDP together with a monthly estimate based on services and industrial production, which have a combined weighting of 93%. After a 0.7% fall in January, partly reflecting weather disruption, monthly GDP rose by 0.6% and 0.7% respectively in February and March. The March reading was 0.6% above the quarter average.

GDP inflation, meanwhile, picked up further last quarter. The deflator for gross value added (GVA) at basic prices – which fully adjusts for the VAT hike and may therefore understate the underlying trend – rose by 1.0%, or 4.0% annualised.

Nominal GVA expansion, therefore, accelerated from 3.6% annualised during the second half of 2009 to 5.1% in the first quarter. Such a growth rate, if sustained, is unlikely to be compatible with the 2% inflation target over the medium term.

The US monetary base (currency plus bank reserves) rose again in the week to Wednesday and is now up by 3.7% from its low a fortnight ago, following a 9.4% contraction between late February and early May. A recovery in the monetary base preceded a rally in equities by three weeks in February / March 2009, by two weeks in June / July and by four weeks in January / February this year – see first chart.

The Eurozone monetary base also rose in the week to last Friday and is up 9.7% since late April – first chart.

Some measures of equity market sentiment look extremely oversold. The Chicago Board Options Exchange equity put / call ratio, for example, is at its highest level since the bear market ended last March – second chart.

The sustainability of any rally in equities may depend on whether central banks continue to expand liquidity. The Fed may be reluctant to reverse fully the earlier contraction of the monetary base unless it believes that market turbulence is a serious threat to the economic recovery. The impact on the base of its dollar swap lending to European central banks has so far proved small – the ECB’s 84-day tender of dollars this week attracted bids of only $1.0 billion. The ECB, meanwhile, continues to state that it will sterilise the liquidity effect of its “non-standard” measures.

A signal that the Fed was turning more expansionary would be an announcement of a reduction in the “supplementary financing programme”, under which the Treasury has issued an additional $200 billion of bills, placing the proceeds in a special account at the central bank. The Treasury could repay maturing bills by running down the balance in this account, thereby boosting bank reserves and the monetary base.

A further reason for caution about any rally is the still-unfavourable balance between global economic and monetary growth. G7 real narrow money, M1, is continuing to expand more slowly than industrial output – third chart.

The fourth chart shows regional equity market performance, including currency, relative to the World index. Europe ex. the UK has underperformed significantly so far this year but the price relative has made higher lows recently, hinting at a turnaround. Extreme investor pessimism about Europe and the euro is already reflected in positioning, while real M1 is growing faster in the Eurozone than in the US, Japan and UK.

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COMMENT:
AUTHOR: APB
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IP: 217.43.167.171
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DATE: 05/24/2010 11:26:13 AM

Excellent work, Simon – thank you. You are always a superb read!
On a technical point – on your chart 3 – am I right in thinking that %ch 12mth in Real M1 and G7 Ind Output gives better asset allocation signals than % ch 6mth…?
I remember thinking that from some of your earlier posts…
Thanks
APB

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COMMENT:
AUTHOR: Simon Ward
DATE: 05/25/2010 10:12:20 AM

Many thanks and, yes, I put greater weight on the 12-month growth rate relationship, though have not formally tested the difference.

The yen, rather than the US dollar, could be the big winner from a loss of confidence in the euro as an international store of value.

More fund managers – a net 51% – believe that the yen is overvalued than any other currency, according to the latest Merrill Lynch global survey. This suggests that they are not positioned for further strength.

The perception that the yen is expensive may reflect its nominal effective (i.e. trade-weighted) exchange rate, which is only 3% below its all-time high reached in January 2008. A correct assessment, however, should be based on the real effective rate, i.e. adjusting for Japan’s superior inflation performance. This remains below its long-run average – see first chart.

Relative monetary policies are an influence on currency performance. Real official interest rates (i.e. relative to the annual rate of change of consumer prices) are much higher in Japan than the rest of the G7. The 3.2 percentage point gap with the US is the largest since 1980 – second chart.

The Fed and ECB have responded to market turbulence by expanding the monetary base – see Friday’s post. The Bank of Japan has yet to follow – third chart. Fed liquidity injections, if sustained, could limit further US dollar gains, deflecting upward pressure onto the yen.

Posts over the last year have argued, probably ad nauseam, that Bank of England and consensus inflation forecasts were too low. April figures delivered another unfavourable “surprise”, with the headline CPI and RPI rates moving up to 3.7% and 5.3% respectively. RPI inflation is now at its highest level since the aftermath of the late 1980s Lawson boom.

Governor King’s latest explanatory letter claims that the overshoot of CPI inflation relative to the 2% target is fully explained by higher oil prices, the rise in VAT and exchange rate weakness. This is dubious. Energy and VAT are unlikely to account for more than 1 percentage point of the 3.7% April headline rate. Sterling’s decline partly reflects monetary policy decisions so the Bank cannot absolve itself from responsibility for the impact on inflation.

The Governor also fails to acknowledge the scale of the Bank’s forecasting error. The central projection in the May 2009 Inflation Report was for CPI inflation to fall to 0.7% by the second quarter of this year. This incorporated the planned VAT rise and was based on a similar effective exchange rate level to today’s. Higher energy prices can account for only about 0.5 of a percentage point of the 3 point forecast miss.

The Bank’s error was to place too much weight on the “output gap” as a driver of inflation while underestimating the impact of sterling’s decline to significantly undervalued levels. It also wrongly believed that low money supply growth would constrain price rises, neglecting that the demand to hold money had been depressed by its imposition of negative real interest rates. The lessons, however, have yet to be learnt, judging from the letter and the latest Inflation Report.

The charts present updated CPI and RPI inflation projections. They incorporate, optimistically, a significant slowdown in core price rises from their recent pace in response to economic slack and smaller import price gains. A hike in the standard VAT rate to 20% is assumed in January 2011, possibly to be pre-announced in the June emergency Budget, while the RPI profile posits an increase in Bank rate to 2.5% by mid-2011. Headline CPI and RPI rates may have peaked in April but are forecast to remain elevated, averaging 3.0% and 4.6% respectively between May 2010 and December 2011. The latest Inflation Report projections are barely more credible than those issued a year ago.

Previous posts have argued that the escalation of the Eurozone sovereign debt crisis and associated weakness in equity markets reflected deteriorating global liquidity conditions. One aspect of this deterioration was a 9.4% contraction in the US monetary base (currency and bank reserves) between late February and early May – see chart.

A key issue for markets, therefore, is whether the crisis results in a significant reinjection of liquidity by central banks. A post last week suggested that the US and Eurozone monetary bases would expand but by less than needed to recreate bull market conditions. The Fed’s response seemed likely to be constrained by strong domestic economic news while the ECB had signalled its intention of sterilising the impact of its bond purchases.

The latest US figures confirm that the Fed has injected liquidity in response to the crisis, resulting in a 2.3% rise in the monetary base in the week to Wednesday – the first increase for seven weeks. This was achieved by the Treasury running down its cash balance at the Fed. Currency swap lending to European central banks should result in a further rise in the base this week. The Fed, however, is unlikely to wish fully to reverse its earlier liquidity withdrawal.

Eurozone monetary base figures for last week – released tomorrow – will be boosted by the six-month repo operation conducted on Wednesday, at which the ECB lent €35.7 billion (equivalent to 2.8% of the monetary base), and the initial impact of its bond purchases. The ECB’s claim that it will sterilise its bond-buying is suspect since it has limited control of the monetary base as long as repo lending is on a full-allotment basis.

Central bank liquidity injections could be laying the foundation for a bottom in equities and other risk assets but caution remains warranted until the US / Eurozone monetary base show more significant and sustained expansion. Note, also, that prior US market troughs over the last 18 months have occurred several weeks after the low in the monetary base – see chart.

The May Inflation Report marks another step towards the demise of inflation-targeting. In a now-familiar routine, the Bank has been forced to raise its near-term inflation forecast significantly but continues to project an eventual decline to below the 2% target, based on a “neo-Keynesian” model emphasising the “output gap” and future fiscal tightening. A recent rise in inflation expectations is downplayed while the alternative “monetarist” view that persistent inflation overshoots reflect an excess of the supply of money over the demand to hold it – with demand depressed by the Bank’s imposition of negative real interest rates – is ignored. The message is that monetary policy, in effect, will be set to accommodate overborrowers, both private and public. Bank and building-society savers can expect a further erosion of their real wealth as post-tax deposit rates remain below “surprisingly resilient” inflation.

Key observations:

• The Governor suggested that the forecast was little changed from February but the inflation numbers are significantly higher out to the third quarter of 2011. The central projection for the current quarter appears to be 3.3%, up from 2.8% in the February Report, while the trough now occurs at about 1.5% in the second quarter of next year versus 0.9% in the first quarter previously (based on unchanged policy).

• The two-year-ahead projection, as in February, is just below the 2% target but with risks tilted slightly to the upside, signalling that the MPC remains firmly in neutral. The careful calibration suggests that this is more an assumption than an evidence-based forecast.

• The Bank remains bullish on the recovery, probably justifiably. The central projection is for GDP to rise by about 7.5% over the next two years (unchanged policy), although with downside risks, so the mean forecast is about 6.5%. On the defensible view that the “output gap” may be only 2% of GDP while potential growth may have fallen to about 2%, spare capacity could be eliminated by late next year. (The Bank, of course, refuses to disclose its own estimates of the “gap”.)

• The chart compares quarterly inflation with the Bank’s central projection a year earlier (unchanged policy). Since 2005, inflation has exceeded the forecast in 17 out of 21 quarters, with a mean error of 0.5 of a percentage point.

• The inflation target was switched from RPIX to the CPI in December 2003. Since then, the CPI has risen at an average rate of 2.5% per annum versus the 2% target while RPIX has increased by 3.1% pa versus the previous 2.5% target. Expressed differently, the level of the CPI today is 3.0% higher than if the 2% target had been achieved on average.

The Chinese authorities have been attempting to tighten monetary policy without raising interest rates or allowing the exchange rate to appreciate. The latest inflation and monetary statistics suggest that their efforts are failing.

Consumer prices rose by 2.8% in the year to April and at a seasonally-adjusted annualised rate of 3.9% over the last three months – see first chart. If this latter rate of increase is maintained, annual inflation will reach 4.0% in August and average 3.2% in 2010, above the 3% target – green line in chart.

Momentum, however, is likely to accelerate further. Chinese inflation follows swings in narrow money, M1, growth – second chart. The annual M1 increase reached a 17-year high of 39% in January and was still 31% in April. Shorter-term growth also remains buoyant – 30% annualised over the last six months. Historically, these rates of expansion have been associated with 20%-plus inflation.

Administrative controls and “moral suasion” have resulted in a more significant slowdown in credit and broad money, M2. Six-month growth rates, however, remain solid, at 18% and 19% annualised respectively. The demand to hold M2, moreover, has probably fallen as inflation has moved above deposit rates. M1 is a measure of transactions rather than savings money and should be a better leading indicator of activity and price pressures.

The prospect of more significant Chinese policy tightening is a further reason for caution about the liquidity backdrop for markets.

Q. Does the Eurozone rescue package change the liquidity backdrop for markets from negative to positive?

A. Possible but doubtful. Most of the package (EU budget funding, Eurozone intra-government loans / guarantees, IMF contribution) has no direct implication for liquidity. The key issues are the scale of ECB government bond purchases and the impact of its expanded lending operations and the US dollar swap on the Eurozone and US monetary base. 

• The ECB states that bond-buying is intended “to ensure depth and liquidity in those market segments which are dysfunctional”. It has given no indication of the possible scale of purchases, in contrast to the Fed and the Bank of England when they embarked on QE.

• Buying must be large to have a significant impact on global liquidity. To boost G7 broad money by 1 percentage point (pp), Eurozone M3 would need to rise by about 3 pp. Assuming a one-for-one impact of bond-buying on the money supply, this would require purchases of €280 billion. (This compares with the ECB’s covered bond purchase programme, announced in May 2009, of €60 billion.)

• The scale of intervention by the Fed to stabilise the US mortgage-backed securities (MBS) market also suggests that large-scale buying will be required. The Fed purchased $1.25 trillion of agency MBS, equivalent to about 25% of the outstanding stock. To buy 25% of outstanding government debt in the PIIGS (Portugal, Ireland, Italy, Greece and Spain) markets, the ECB would need to spend €420 billion.

• The ECB has indicated that its bond purchases will be sterilised but the Eurozone monetary base may nonetheless expand because of the simultaneous decision to reintroduce full-allotment three- and six-month repo operations. In contrast to the US and UK QE variants, however, there is no explicit aim to boost banks’ reserves.

• The US dollar swap arrangements with the Fed have the potential to increase the US monetary base. The Fed, however, has been draining bank reserves in recent weeks, probably in response to stronger economic news, suggesting that any expansionary impact from swap lending will be sterilised.

Conclusion: The rescue package will suppress contagion and ease near-term financing but does not remove longer-term solvency concerns based on doubts about the willingness of electorates in the PIIGS to accept fiscal stringency. There is a risk that investors will use a bounce in prices to accelerate capital withdrawal. Central bank actions have the potential to be a “game-changer” in terms of the liquidity backdrop for markets but the ECB’s reluctance to quantify bond-buying and its bias towards sterilisation argue for caution. A more positive interpretation would be warranted in the event of an early significant pick-up in the Eurozone and US monetary base.

None of the three main parties has been honest with the electorate about the scale of fiscal retrenchment needed to stabilise the public finances but the Conservatives have been most vocal about the dangers of failing to make an early start on reducing the deficit. Their inability to achieve a clear mandate indicates that the new government, whatever its composition, will face strong public resistance to the required actions.

The stability of the pound and gilt yields for most of the campaign had led some to suggest that markets were comfortable with the prospect of an inconclusive result. This stability, however, partly reflected a “safe-haven” influx of capital fleeing peripheral Eurozone economies. The risks that could be downplayed while the polls fluctuated have now crystallised. The initial negative market reaction is more likely to extend rather than be reversed on further reflection.

The “best-case” scenario for markets is a minority Conservative government that presses ahead with an early emergency budget setting out a credible deficit-reduction programme. The need, however, to appease collaborators suggests that this would be less ambitious than required. The alternative scenario of a Lab-Lib coalition, in theory, would delay any new fiscal announcements until an autumn Pre-Budget Report. In either case, the credibility of medium-term proposals would be low given the likelihood of another election within a year or so.

The notion that delaying fiscal tightening will boost near-term growth prospects is a fallacy. Policy uncertainty will cause businesses to delay plans to expand investment and hiring while consumer caution will similarly increase. A likely rise in the “risk premium” in UK market interest rates will act as a further drag on the recovery. Inflation expectations, meanwhile, may firm, with markets suspicious that the Bank of England will restart gilt-buying in the event of deficit-financing difficulties, even if this conflicts with its inflation-targeting remit.