Author: admin

Bank of England gilt purchases have contributed to a significant pick-up in broad money growth but this has yet to be reflected in higher cash balances of non-financial corporations, according to May monetary statistics released today. However, corporate liquidity should improve as companies continue to take advantage of more favourable market conditions to issue new shares and bonds.

The Bank of England’s monthly proxy for its favoured broad money measure – M4 excluding money holdings of financial intermediaries – rose by 0.2% in May after a 1.1% gain in April. Chain-linking the monthly proxy to “official” data showing a 1.5% rise in the first quarter, broad money has risen at a healthy 6.7% annualised rate so far in 2009.

Moreover, this understates liquidity growth because households and companies have increased their holdings of Treasury bills by £18 billion so far this year – equivalent to 1.2% of the Bank’s broad money measure. In other words, a wider aggregate including Treasury bills has risen by over 9% annualised in the first five months.

As expected, the Bank’s gilt purchases have been reflected initially in higher cash balances of financial institutions (i.e. excluding intermediaries). M4 holdings of households and private non-financial companies have risen at an annualised rate of 3.2% so far in 2009, well below the 6.7% increase in overall broad money. (Again, this understates liquidity growth because households and non-financial companies are likely to account for a significant portion of the rise in Treasury bills outstanding.)

Non-financial corporate M4 holdings have risen by just £1 billion, or 0.8% annualised, so far this year, despite sterling capital market issuance of £18 billion. This partly reflects a large-scale repayment of foreign currency borrowing in recent months. Assuming that this slows, corporate liquidity should improve as high financial sector cash balances facilitate further significant issuance. (The Bank’s numbers imply that financial companies’ M4 holdings – excluding intermediaries – have risen by about £25 billion so far in 2009, equivalent to annualised growth of more than 20%.)

The fall in monthly broad money growth from 1.1% in April to 0.2% in May is partly explained by a smaller boost from QE last month, with banks and building societies accounting for £8 billion of the £27 billion of gilts acquired by the Bank of England – see table. Bank purchases from the banking system have no impact on broad money unless banks use the cash released to increase private sector lending.

This QE “leakage”, coupled with the lack of a recovery to date in non-financial companies’ money balances, suggests that the Monetary Policy Committee will expand asset purchases by a further £25 billion to the £150 billion current maximum at its meeting next week, while simultaneously requesting Treasury authority for a higher limit.

The table below provides further evidence that money leads credit around the trough of the economic cycle.

The table dates the lows in the six-month rates of change of UK M4 and M4 lending around the recession troughs in the mid 1970s, early 1980s and early 1990s. Money bottomed about a year before credit in all three cases.

Six-month M4 growth – on the Bank of England’s adjusted measure – appears to have troughed in the fourth quarter of 2008. Based on the historical lead, bank lending could remain weak until late 2009 / early 2010.

Providing recent faster money growth is sustained, an economic recovery can coexist with ongoing lacklustre credit trends. Lending constraints could become an issue as the upswing develops but by that stage banks’ balance sheets and risk appetite may have improved significantly. 

A simplistic monetarist view is that countries with higher rates of inflation-adjusted money supply growth should experience stronger economic and equity market performance.

The first chart shows six-month changes in real broad money across the major developed economies. At the start of 2009, real money trends were much stronger in the US, Canada and Australia than in Japan and Europe.

The second chart shows year-to-date equity market performance for the same group of countries, including the impact of currency fluctuations and expressed relative to the World index. As suggested by money supply growth, Canada and Australia have outperformed significantly, while Japan and Europe ex. the UK have lagged the global average.

China is not included in the charts. Its monetary growth and equity market performance have been stronger than in any of the developed countries shown.

The main deviation from the monetarist relationship so far this year has been the relative weakness of the US stock market, despite monetary strength in late 2008 / early 2009. This may partly reflect a drag from much heavier equity issuance than in other markets. US relative performance could improve as issuance abates, although the monetary backdrop is less favourable than at the start of 2009 – see earlier post.

Real money growth has accelerated in the UK and to a lesser extent Japan since early 2009 while slowing in the Eurozone – first chart. Since the start of the second quarter, UK equities have outperformed the other markets with the exception of Canada. Assuming that monetary trends continue to benefit from QE, UK relative gains could be sustained during the second half.

As reported in today’s FT, British Bankers’ Association (BBA) figures for May show a £200 million fall in sterling lending to private non-financial companies. The report states that “a key objective of the Bank of England’s “quantitative easing” programme … is to encourage more private sector lending”, suggesting that the Bank will be disappointed by the BBA news.

Three points are worth noting. First, a £200 million decline is insignificant, amounting to 0.07% of outstanding BBA member lending to private non-financial companies. Moreover, the BBA statistics cover only 65% of total loans by UK-based banks to non-financial firms, according to Bank of England data. The flow of total lending exceeded the BBA flow by an average of £500 million per month over the six months to April. (The Bank will publish its May data on 29 June.)

Secondly, the key objective of QE is to boost the money supply not lending, although credit trends should revive if the policy succeeds in generating an economic recovery. The Bank of England’s website explanation of QE places money rather than credit at the centre of the transmission mechanism:

Asset purchases increase the supply of money directly into the wider economy which should boost spending. … The seller of an asset to the Bank can spend the new money it receives on goods and services which directly adds to overall spending or it can purchase other assets which will tend to boost asset prices more broadly and provide an indirect spur to spending.

Thirdly, to monitor the impact of QE, the MPC has stated that it will pay close attention to “the growth rate of broad money, the cost and availability of corporate borrowing, measures of inflation and inflation expectations, and developments in nominal spending growth”. The list does not include the volume of bank lending to companies, because the MPC recognises that lending weakness may reflect demand factors rather than supply constraints – including firms choosing to raise funds from markets rather than the banks.

The MPC will be encouraged by recent faster money growth, higher corporate equity and bond issuance and signs of a stabilisation in inflation expectations and nominal spending. In assessing the extent of improvement in the “cost and availability of corporate borrowing”, the Committee is likely to place high weight on its second-quarter Credit Conditions Survey, released on 2 July.

Bank of England gilt purchases have contributed to a pick-up in UK broad money growth. In the US, however, M2 expansion has slowed since early 2009, despite ongoing large-scale bond-buying by the Federal Reserve – see first chart. What explains this divergence?

Central bank lending or asset buying has a direct positive impact on the broad money supply only when transactions are conducted with domestic non-banks. One possible explanation for the UK / US monetary divergence is that the Bank of England has been buying securities from non-banks while the Fed has been buying from banks.

Available evidence, however, does not support this interpretation. For example, US flow of funds accounts for the first quarter show that Fed purchases of agency and mortgage-backed securities were more than accounted for by sales by the household sector (which includes domestic hedge funds). Commercial banks’ holdings of such securities were little changed last quarter.

Rather than ineffective bond purchases, the US M2 slowdown appears to reflect two other factors absent in the UK. First, commercial bank credit has contracted by 3% (not annualised) since December 2008. By contrast, UK M4 lending rose by about 2% between December and May (based on the Bank of England’s adjusted measure excluding transactions with financial intermediaries).

Secondly, the monetary impact of the Fed’s bond-buying has been offset by a contraction of its liquidity swap lending to other central banks. Swaps ballooned in late 2008 as policy-makers sought to alleviate an international shortage of dollars. Some of the cash is likely to have flowed back to the US, contributing to faster M2 growth late last year. This process has reversed in 2009: liquidity swap lending has contracted by $405 billion since the start of the year – almost as large as the Fed’s $487 billion combined purchases of Treasuries, agencies, mortgage-backed securities and commercial paper.

As well as contributing to the slowdown in broad money M2, the fall in swap lending has neutralised the impact of the Fed’s bond purchases on the monetary base M0 (i.e. currency plus bank reserves), which has been static since the start of the year. In the UK, however, M0 has surged since the Bank of England embarked on QE, with annual growth recently overtaking the US – second chart.

Slower M2 growth, should it persist, is a threat to US economic prospects but there are grounds for expecting an improvement. Recent credit weakness partly reflects heavy destocking, which is now coming to an end. Similarly, the contraction in the Fed’s swap lending is probably largely complete – the amount outstanding is down to $149 billion from a December peak of $583 billion. As these drags abate, monetary trends should be dominated by the positive impact of ongoing Fed securities purchases.

Monetary and financial statistics for May released today are encouraging in three respects.

First, the Bank of England’s proxy measure for M4 excluding money holdings of financial intermediaries probably grew respectably, following a hefty 1.0% gain in April. The Bank currently has insufficient information to produce a firm estimate but headline M4 rose by 0.2% in May and was again depressed by intra-banking-group transactions – excluded from the proxy measure. Based on available evidence, the proxy may have risen by 0.5% or more last month.

Secondly, M4 lending – excluding the effects of securitisations and loan transfers – bounced back to show 0.9% growth in May after a rare 0.3% decline in April. As with M4, the rise would have been larger but for a decline in intra-group business. At the margin, this should lessen MPC concerns that lending constraints will be a major impediment to an economic recovery. (The Bank’s latest Trends in Lending survey, also released today, is gloomy but Lending Panel banks report an ongoing modest recovery in mortgage approvals and a small net rise in corporate loan facilities in May.)

Thirdly, consistent with quantitative easing improving companies’ access to non-bank finance, private non-financial firms raised a net £4.1 billion from issues of bonds, shares and commercial paper in May, up from £3.1 billion in April and well above the monthly average of just £400 million over 2003-08 – see chart. Companies have raised a net £13.6 billion in these markets so far in 2009, equivalent to 2.7% of outstanding sterling bank borrowing at the end of 2008.

The Monetary Policy Committee has been encouraged by recent better economic news and a pick-up in “adjusted” M4 but retains the view expressed in the May Inflation Report that further easing is likely to be required to prevent inflation from undershooting the target over the medium term, according to minutes of the June meeting released today.

This suggests that the odds slightly favour the MPC expanding asset purchases to the £150 billion current maximum at its July meeting, while simultaneously seeking Treasury authority for a higher limit. However, the Committee could yet choose to suspend QE at £125 billion if forthcoming business surveys and monetary data show further improvement. (The Governor’s Mansion House speech this evening may provide more information.)

Labour market statistics also released today continue the recent pattern of better-than-expected news. The monthly rise in claimant-count unemployment slowed to 39,000 in May, down from a peak of 137,000 in February and the smallest increase since July 2008. This slowdown should soon be reflected in the lagging Labour Force Survey unemployment measure – see first chart.

Labour demand appears to holding up better than many feared. The monthly number leaving the claimant count has risen steadily so far this year (admittedly partly reflecting some claimants exhausting entitlements), while the rate of decline of job vacancies has eased. Indeed, the 6% drop in vacancies in the three months to May is consistent with other evidence that the economy has stopped contracting – second chart.

The “best” measure of the UK broad money supply – M4 excluding money holdings of financial intermediaries – grew by 1.0% in April, according to a monthly proxy made available by the Bank of England today. Chain-linking this increase to “official” first-quarter numbers, adjusted M4 is estimated to have risen at a 7.8% annualised rate in the first four months of 2009, up from 3.0% during the second half of 2008. This suggests that QE is working and supports economic recovery hopes.

The 1.0% rise in the adjusted measure in April compares with an increase of just 0.1% in M4 holdings of households and non-financial corporations. The big gap implies that cash balances of financial institutions, excluding intermediaries, rose strongly, probably reflecting the direct and indirect impact of Bank of England asset purchases. Reinvestment of this cash should boost asset prices and money holdings of corporations, as institutions subscribe for new equity and bond issues.

The April broad money rise would have been larger but for a contraction of 0.1% in bank and building society lending to households and non-financial corporations – the first monthly fall since 1993. Lending to households slowed to £2.2 billion, the lowest since August, while corporations repaid £4.7 billion of bank debt, partly out of the proceeds of recent capital issues (sterling issuance totalled £13.7 billion in the three months to April).

Bank of England gilt purchases of £29 billion in April offset £18 billion of DMO (Debt Management Office) issuance, reducing the market-held stock by £11 billion. Sectoral figures show that gilt holdings of overseas and UK non-bank investors fell by £11 billion and £3 billion respectively, while banks and building societies bought £3 billion – see table.

When the Bank buys from a UK non-bank investor, M4 rises as the investor’s bank account is credited; there is no such first-round effect with a purchase from a foreign investor, since overseas deposits are excluded from M4. Foreigners, however, appear to have used cash from gilt sales to buy assets from UK institutions and subscribe to new issues, thereby boosting M4 and allowing UK companies to repay bank debt.

Annual growth in adjusted M4 appears to have remained stable at 4.2% in April, since there was an identical 1.0% monthly rise in April 2008. In real terms, i.e. relative to retail prices, the annual rate of change has recovered from a low of -0.7% in September last year to 5.5%. Narrow money trends have also improved, with the annual change in real M1 – currency and sight deposits – up from -5.8% in October to 1.4% in April.

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COMMENT:
AUTHOR: simon slater
EMAIL: sslater7@aol.com
IP: 195.72.179.234
URL:
DATE: 06/16/2009 01:23:13 PM

Where is this monthly ‘proxy’ for adjusted M4 from? I thought the BoE were only starting to publish monthly data for this in the autumn, with only only quarterly figures available until then?

The smaller-than-expected fall in UK annual consumer price inflation in May partly reflects the continuing after-effects of sterling’s plunge during 2008, discussed in earlier posts (e.g. here). With the exchange rate recovering recently, however, inflation prospects are improving, although the MPC’s forecasts are too optimistic.

Headline CPI inflation edged down from 2.3% in April to 2.2% in May but remains above target and would be significantly higher but for December’s VAT cut. Assuming retailers passed on half of the VAT reduction, “true” inflation is probably 2.7-2.8%. (The CPI at constant tax rates shows a larger rise, of 3.3%, but assumes unrealistically that the cut was passed on in full.)

As well as the VAT change, slowing food and energy prices have contributed to the recent decline in the headline rate. Core trends, however, remain sticky: the annual increase in the CPI excluding unprocessed food and energy moved up from 2.0% in April to 2.1% in May and would be an estimated 2.7% without the VAT reduction (again assuming 50% pass-through).

The impact of the lower exchange rate is evident in less favourable price trends for such categories as clothing and footwear, audio-visual goods and package holidays. Currency weakness has also reduced the benefit of lower global commodity prices: a 7.8% annual rise in the UK CPI for food and non-alcoholic beverages in May compares with an increase of just 0.3% in the Eurozone.

Sterling’s recent rally, however, will curb import price pressures. The chart shows annual rates of change of manufactured import prices and the effective exchange rate, plotted inverted. Import cost inflation has already slowed from an annual 15% in December to 10% in April and prices are likely to fall later in 2009 if the effective rate remains at its current level.

The MPC appears once again to have underestimated current-quarter inflation in its latest Inflation Report: the 2.25% April / May average compares with a central projection of 1.9%. The MPC was forecasting a fall to just 0.4% by the fourth quarter but is likely to revise this up in the August Report, reflecting recent higher-than-expected outturns, better economic data and higher oil prices.

The recent sharp rise in US Treasury yields may partly reflect supply pressures and investor worries about longer-term inflationary risks from quantitative easing (QE) but the key driver has been a recovery in economic momentum.

The first chart shows three-month changes in the 10-year Treasury yield and the Institute for Supply Management (ISM) manufacturing new orders index – a good summary measure of economic momentum. A positive correlation is apparent, with the recent yield surge coinciding with the largest three-month rise in the new orders index since 1983.

The relationship suggests that the direction of yields depends not on the rate of economic growth but on whether it is accelerating or decelerating. When the new orders index reached a record low of 23 last December, it was clearly much more likely to rise than fall, implying that Treasuries were high risk. The bearish case is now less clear-cut – even though the ISM index is back above 50, signalling economic expansion.

To assess Treasury market prospects, therefore, it is helpful to have an idea where the new orders index could be heading. The second chart compares the recent revival with an average of five prior recoveries from troughs when the index fell below the 40 level. (The troughs occurred in January 1958, December 1974, June 1980, January 1991 and January 2001.)

The historical pattern suggests that the new orders index could rise further to 55-60 in the short term. Interestingly, however, the average registers a peak in August 2009, treading water over the autumn before a further move up around year-end. If the current cycle follows this template, Treasuries could enjoy a short-term rally later this summer, even in the context of an ongoing economic recovery.