Category: Money Moves Markets

The Bank of England’s favoured broad money measure – M4 excluding money holdings of “intermediate other financial corporations” (i.e. companies classified as non-banks that act as a conduit for interbank business) – contracted by 0.7% in October following a 0.8% September decline. This suggests a serious monetary deficiency that threatens to abort an economic recovery.

On closer examination, however, these falls are entirely explained by a large drop in M4 held by other financial corporations (OFCs) not classified as “intermediate”. By contrast, the combined money holdings of households and non-financial corporations – i.e. M4 excluding all OFCs – rose by 0.3% and 0.2% respectively in September and October, with annual growth reaching an eight-month high of 2.9%. This suggests that liquidity created by official gilt-buying is filtering down to “end-users” responsible for spending decisions.

The large fall in money holdings of “non-intermediate” OFCs, moreover, appears to be an artefact of the Bank of England’s seasonal adjustment procedure. This grouping includes insurance companies and pension funds, investment and unit trusts, other fund managers and securities dealers. M4 holdings contracted by a seasonally-adjusted £29 billion, or 9%, in September and October (see Bankstats table A2.2.3, T6, column 4). Yet non-seasonally-adjusted figures show a decline of only £5 billion (derived by summing changes for the listed industries in table C1.1, T95-96). The £24 billion discrepancy accounts for the entire decline in M4 excluding intermediate OFCs in September and October.

An alternative approach is to use the non-seasonally-adjusted money holdings of “non-intermediate” OFCs when calculating the M4 measure. This is defensible on two grounds: it is unclear why these holdings should exhibit a seasonal pattern and there is insufficient history to estimate reliable monthly seasonal factors. On this basis, M4 excluding intermediate OFCs rose by 0.3% in October after a 0.2% September drop. While still weak, this is probably consistent with economic growth since the demand to hold broad money has been depressed by low deposit rates and reviving risk appetite.

Other features of the October monetary data support optimism about economic prospects. Narrow money M1 has accelerated strongly, rising at a 16% annualised rate over the last three months – see chart. Meanwhile, there were further rises in October in the corporate liquidity ratio (i.e. non-financial companies’ sterling and foreign currency money holdings divided by their bank borrowing) and mortgage approvals for house purchase, to their highest levels since September 2007 and March 2008 respectively. 

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COMMENT:
AUTHOR: Giles
EMAIL: gileswilkes@googlemail.com
IP: 217.34.50.8
URL: http://www.freethinkingeconomist.com
DATE: 01/11/2010 11:09:24 AM

This is a very late question, so I would not be at all surprised if it went unanswered.

But given how M4 is created whenever there is a loan, how is it possible for the M4 lending/M4 ratio to be substantially above 1?

I can understand how it can for the corporate sector: i.e. Company A gets a $100 loan from Bank B to invest. It spends $50 of the deposit created on an asset from non-corporate private sector. The seller of the asset acquires $50. M4 is still $100; corporate liquidity ratio is 0.5; non-corporate private sector now has $50 more. If that $50 does not return to the corporate sector, for some reason, then corporate liquidity suffers.

Is this an accurate description of how corporate liquidity can fall?

many thanks

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COMMENT:
AUTHOR: Simon Ward
DATE: 01/18/2010 02:55:47 PM

Every loan creates an equivalent liability on the other side of the balance sheet but this will not necessarily be an M4 deposit. For example, if the company taking out the loan buys inputs from a foreign firm the cash may show up as a foreign deposit, not included in M4. Or, in your example, the seller of the asset may use the proceeds to buy newly-issued bank equity – this purchase would reduce M4 and thereby cancel out the increase due to the loan. M4 lending is higher than M4 currently because UK banks relied partly on foreign borrowing to fund the domestic credit boom of the last decade.

Since its buying programme began in March, the Bank of England has swallowed up more gilts than the Debt Management Office (DMO) has issued. So which sector of the market has reduced its holdings?

The table, derived from Bank of England and DMO data, shows issuance and transactions by sector between March and October, with the prior eight months included for comparison. The Bank’s buying exceeded DMO net sales by £26 billion in the latest eight months. The counterpart was a £24 billion decline in holdings of the “non-bank private sector”. The combined holdings of overseas investors, banks and building societies were little changed.

The non-bank private sector comprises households, non-financial companies, insurance companies and pension funds, and other financial institutions. A monthly breakdown is not available but quarterly figures show that insurers and pension funds bought £12 billion of gilts between April and September, non-financial corporate holdings were little changed while households and other financial institutions sold £6 billion and £35 billion respectively.

The other financial category includes unit and investment trusts, other fund managers, including hedge funds, and securities dealers. Limited further information is available but the recent sales are likely to have been dominated by hedge funds and dealers.

These other financial firms have successfully traded the gilt market in recent years. They were heavy buyers before and during the financial crisis, boosting their holdings from £45 billion at the start of 2006 to £137 billion by the end of 2008. The 10-year benchmark yield averaged 4.7% over this period.

They started to unload their position in the first quarter of 2009 as the Bank began buying. Sales accelerated during the second and third quarters, when the 10-year yield averaged 3.7%. Their holdings had fallen to £96 billion by the end of September.

Gilt market optimists argue that the ending of the Bank’s buying programme will be offset by stepped-up demand from insurance companies, pension funds and banks. Inflows to insurers and pension funds, however, have been weak while their liquidity ratio has fallen significantly – see chart. Banks’ need to increase their holdings of liquid assets, meanwhile, has been satisfied recently by a rise in their reserve balances at the Bank of England – see memo line in table.

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COMMENT:
AUTHOR: Peter Norman
EMAIL: peter@gendan.co.uk
IP: 86.128.180.98
URL:
DATE: 01/13/2010 05:13:13 PM

Simon, it seems to me that the BoE and DMO have rigged the gilt market for the last 10 months through the QE scheme. Even though the Maastricht Treaty forbids signed-up governments financing their debt by printing money, GoBro has worked around the law by backdoor trickery. The apparent “new issues” of £200bn gilt, meant to cover government deficit, went nowhere. All this money is now in the economy in the form of cash and reserve balances – the same result as a blatant money printing policy akin to Mugabe’s Zimbabwe. I’d say there’s no way the BoE can unload their gilt stockpile back to the market in the next 10, maybe 20 years. The MPC and BoE are intent on sucking in some of this money over-supply by issuing BoE bills (more commissions for the boys in braces!). Money Supply drifts further into uncharted waters.
After a year with no genuine buyers in the gilt market, next month the DMO has to find some, and at record levels (£200bn plus a year). Those who dumped their gilt holdings last year should soon be able to buy them back with a profit.

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COMMENT:
AUTHOR: Simon Ward
DATE: 01/18/2010 01:16:06 PM

The first £125 billion of QE was justified on the basis that "money printing" was needed to offset "money destruction" caused by contracting bank balance sheets. With the banking system clearly stabilised by last summer, however, the further QE expansions announced in August and November were questionable and, by keeping gilt yields comfortably low, may have contributed to the government’s decision to postpone fiscal tightening. Sales of bills by the Bank of England do not reverse QE – in particular, they have no contractionary impact on the M4 money supply. Bills will be auctioned so there will be no commission windfall.

A post last May suggested that house prices were bottoming, in contrast to consensus expectations at the time of a further 10-15% decline. This proved insufficiently upbeat. The Halifax index had already troughed in April and rose by 9%, or 14% annualised, over the subsequent eight months to December. The Nationwide index was also 9% above its low by December.
 
The first chart compares the quarterly evolution of real house prices since the peak in the third quarter of 2007 with their development after three prior major tops, in 1973, 1979 and 1989. (The comparison is based on the Nationwide measure, which has a longer history than the Halifax, deflated by the retail prices index.) Up to the first quarter of last year, the fall in real prices was closely tracking the major declines of 1973-77 and 1989-96. This suggested a further loss of 15-22% – roughly consistent, given inflation, with the consensus forecast for nominal prices.
 
After the first quarter, however, real prices moved sharply higher to converge with the less severe 1979-82 decline.
 
What explains the sudden shift from early 2009? The cut in Bank rate from 5.0% in September 2008 to 0.5% in March 2009 led to a steep drop in mortgage interest bills, reducing delinquencies and forced selling. Household interest payments fell from 10.5% of disposable income in the third quarter of 2008 to 6.9% a year later. This is close to the historical low (since 1987) of 6.7% in the first quarter of 2002.
 
Perhaps the decision to embark on quantitative easing in February 2009 also contributed to the shift. This may have boosted longer-term inflationary expectations, thereby increasing the attraction of housing as a store of real value relative to other assets, particularly cash savings.
 
If real house prices were to continue to follow their path after 1979, they would rise by 4% in the year to the fourth quarter of 2010 and 7% in the subsequent year. Assuming retail price inflation of 3%, the cumulative nominal gain over the two years would be 18% – sufficient for the Nationwide measure to surpass its 2007 peak by late 2011.
 
Such a scenario would imply housing remaining expensive by historical standards. As argued in the previous post, the “national rental yield” is a better measure of valuation than the house price to earnings ratio. This yield ended 2009 at about 3.4% versus a long-term average of 3.6%, implying overvaluation of about 5% – see second chart. (The yield rose slightly during 2009, despite the recovery in house prices, because of rapid growth in the national accounts rents measure.)
 
Historically-high valuations, however, may prove sustainable as long as real interest rates remain low or – in the case of cash rates – negative. The gap between the rental yield and the real yield on long-term index-linked gilts is at a record high – second chart.
 
The housing market recovery would be at risk if the MPC were to restore a positive real level of official interest rates. The consensus view, however, is that Bank rate will remain below both current inflation and the 2% target throughout 2010.

First, the annual rate of change of G7 real money supply M1 remains far above that of industrial output. As detailed in a previous post, world equities have outperformed dollar cash by 11.1% per annum on average when this condition has been met. Real money growth, however, could cross below output expansion this spring – see first chart.

Secondly, the US monetary base, having fallen in late 2009, is rebounding – second chart. A Wall Street Journal article last year by Andy Kessler argued that changes in the Fed’s liquidity policy, reflected in the monetary base, were driving equities and other markets. The decline from late November was the result of a build-up of cash in the US Treasury’s “general account” at the Federal Reserve, partly due to repayments of TARP funds; this reduced banks’ reserves at the Fed. The Treasury, however, is now deploying this cash, reversing the impact: the general account balance rose from $13 billion on 25 November to $167 billion on 6 January but had fallen to $124 billion by 13 January.

Thirdly, US Treasury yields have fallen since the start of the year as investors have pushed back expectations for Fed tightening in the wake of last week’s December employment report. The two-year yield is down by about 25 basis points.

Fourthly, US retail interest in equities remains muted but could pick up as economic news continues to improve. Equity mutual funds suffered a further outflow in December and early January, in contrast to substantial – but slowing – buying of bonds.

Some commentary has claimed that this week’s Royal Institution of Chartered Surveyors (RICS) survey for December signals renewed housing market weakness. Hardly. The survey suggests a slowdown in price gains – unsurprising given a 14% annualised rise in the Halifax index over the last eight months – but a further increase in turnover.

True, the buyer enquiries index has fallen significantly from its peak in June last year. It remains, however, firmly in positive territory, consistent with further gains in mortgage approvals and transactions – see first chart. The new instructions index, meanwhile, has picked up recently but is still below buyer enquiries, suggesting that demand continues to outstrip supply.

Commentators have also interpreted the British Retail Consortium (BRC) December sales survey, showing a rise in annual sales growth from 4.1% to 6.0%, as evidence of a pick-up in consumer spending. The increase, however, may have been due to higher inflation rather than stronger volumes – the annual gain in the BRC’s shop price index accelerated from 0.2% to 2.2% in December.

Manufacturing output figures for November, released today, were disappointing, showing no increase from October. Relative to its pre-recession peak, however, UK output is at a similar level to France and higher than in Germany, Japan and Italy – second chart. In other words, the smaller recent recovery in the UK partly reflects a less severe prior decline.

Markets were mildly disappointed by December US payroll numbers released on Friday, showing a monthly fall of 85,000, but the Conference Board’s employment trends index (ETI) continues to signal a labour market recovery.

The ETI is designed to lead turning points in payrolls and has eight components: consumers’ assessment of job availability, initial unemployment claims, small firm unfilled vacancies, temporary employment, involuntary part-time working, job openings, industrial production and business sales. It bottomed in June last year, edging higher into the autumn before rising strongly in November and December. All eight components contributed to last month’s gain – more details here.

Historically, the index has led troughs in payroll employment by between one and four months – see chart. The June bottom was, therefore, consistent with a low in payrolls by October. They increased marginally in November before slipping back in December. The ETI suggests that last month’s decline will be either revised away or more than offset by a rise in early 2010.

The OECD’s leading indices are designed to predict industrial production and typically lead by three months or so. November figures released on Friday show further large gains across major developed and emerging economies. A combined G7 plus “E7” indicator suggests that output will continue to recover rapidly in early 2010 – see first chart.

Further evidence of resurgent industrial activity is provided by recent Asian trade data. The second chart shows combined dollar exports and imports of China, Korea and Taiwan, adjusted for seasonal variation. Both surged in December, with imports surpassing their July 2008 peak. 

The annual increase in the British Retail Consortium (BRC) shop price index – a measure of goods price inflation – jumped by two percentage points to 2.2% in December. The BRC index is a narrower measure than the official consumer price index for goods but this increase bodes ill for the December CPI report to be released on 19 January.

The chart compares the BRC indices for food and non-food goods with roughly-comparable CPI definitions. BRC food inflation tracks the CPI measure reasonably closely and climbed from an annual 2.8% to 3.7% in December. This represents an unfavourable surprise since the increase cannot be explained by the VAT effect – most food items are not VAT-able.

The annual change in the BRC non-food index rose from -1.2% to 1.4% in December, largely reversing a 2.8 percentage point decline in December 2008 due to the VAT cut. The annual change in the CPI for “non-energy industrial goods” fell by 2.2 percentage points in December 2008; a similar reversal would imply a rise from 1.3% to more than 3% last month.

Overall CPI inflation, including services as well as goods prices, fell from an annual 4.1% to 3.1% in December 2008. Higher BRC food inflation, the jump in the non-food measure and an unfavourable petrol price base effect suggest a similar-sized increase in December 2009. The forecast in an earlier post of a rise in annual CPI inflation from 1.9% in November to 2.6-2.7% last month may prove conservative.

Retail investors continued to pile into unit trusts and OEICs in November, buying a net £2.4 billion, according to Investment Management Association figures released today. Inflows are on course to reach a record £26 billion for 2009 as a whole – the previous highest annual total was £17.7 billion in 2000.

The November performance was particularly impressive given strong competition from National Savings, which attracted £2.8 billion, mostly into now-withdrawn “guaranteed growth and income bonds” offering a premium yield. Equity funds again enjoyed the strongest inflow (£930 million), followed by property (£420 million) and balanced (£250 million). Bond fund sales slumped to a 13-month low (£190 million), probably reflecting the National Savings effect.

Retail mutual fund inflows amounted to 1.2% of M4 excluding money holdings of “other financial corporations” in the six months to November. With investors reallocating portfolios away from cash, the sum of money growth and mutual fund flows is probably a better guide to liquidity support for the economy than M4 itself. This indicator – the green line in the chart – continues to revive, supporting recovery hopes. 

Investors are fearful that the coming election will produce a hung parliament and a weak minority government unable to tackle the gaping hole in the public finances.

They are right to be worried. The peculiarities of the electoral system mean that the Conservatives need to win a much larger share of the vote than Labour to obtain a majority of seats in the House of Commons. In addition, the economy – a key electoral battleground – is currently less unfavourable for Labour than is widely assumed.

The scale of the Conservative challenge is illustrated by “swingometer” calculators that project numbers of seats based on voting intentions. Assuming a uniform national swing, the Tories need to win at least 40% of the vote and lead Labour by 10 percentage points to achieve a Commons majority. Labour, by contrast, requires only a one percentage point advantage for an outright victory.

Recent polls have been volatile but on average show a narrowing of the Conservative lead since the autumn. The last four ICM polls since October, for example, have reported Tory/Labour differences of 17, 13, 11 and nine percentage points respectively.

Based on historical analysis of influences on voting intentions, Labour’s mini-revival is no fluke but reflects better economic trends. The Tory lead, moreover, could be cut further over the near term, magnifying worries about a hung parliament.

The boost, however, is likely to be temporary, with the economy turning against the government again from early 2010. This suggests that Labour’s chances of frustrating the Tories will diminish the longer an election is delayed.

With gross domestic product (GDP) yet to recover after a 6% plunge, it is controversial to claim that the economy has become less of drag for Labour. Voters, however, focus on influences on their personal finances rather than abstract concepts such as GDP.

Historically, support for the governing party relative to the main opposition has benefited from rises in pay growth and house price inflation while suffering when general inflation, interest rates and unemployment increase.
 
In early 2009, Labour support was eroded by a sharp rise in jobless numbers, widespread pay freezes and falling house prices. The damage, however, was limited by Bank of England interest rate cuts and a big decline in inflation, partly due to last year’s VAT reduction. More recently, the increase in unemployment has slowed sharply and house prices have recovered.

Based on current economic readings, the surprise is not that the Tory lead has eroded but that it remains at about 10 percentage points. The historical analysis predicts a much smaller gap, consistent with Labour being the largest party in a hung parliament.

On one view, Labour’s failure to rally by more reflects the party’s core unpopularity, implying dismal electoral prospects. The polls, however, may simply be reacting with a longer lag to economic changes, suggesting a further narrowing of the gap.

The trouble for Labour strategists is that the current economic boost is likely to prove short-lived. Rising inflation, in particular, threatens to undermine government support in early 2010.

The annual rate of change of the Retail Prices Index has already moved up from a low of minus 1.6% in June to plus 0.3% in November. It is likely to climb to about 4% by spring 2010 as a result of the VAT reversal and higher energy and housing costs.

Labour has a window of opportunity. The party’s strategists must aim to narrow the gap between its poll rating and current economic “fundamentals” and – if successful – call an early election. The arithmetic gives Labour a good chance of leading a minority government with only a modest further recovery in its support.

Delaying until May, however, is likely to prove fatal. Poor trade figures supposedly lost Harold Wilson the 1970 election. Could surging inflation do the same for Gordon Brown in 2010?
 
An edited version of this article appeared in today’s Daily Mail.