Category: Money Moves Markets

While the primary cause appears to be relatively loose UK monetary conditions, sterling’s recent slide was given an additional fillip last week by comments by Bank of England Governor Mervyn King again welcoming a weaker pound. This extends a previously-documented pattern of the Governor’s public utterances coinciding with currency depreciation.

Since August 2008, Mr King has presented at five Inflation Report press conferences and given four set-piece speeches. A strategy of shorting the effective index at the close before each appearance and covering the position 24 hours later would have been profitable on all nine occasions. Assuming no gearing, the strategy would have returned a cumulative 11.9% over nine trading days – an annualised gain of more than 2000%.

The benefits of sterling depreciation were questioned in a post last December, which suggested that the inflation cost would be greater than assumed by the MPC and the consensus; this appears to have been borne out by disappointing CPI outturns this year. Official remarks are unlikely to have any lasting effect on currency movements but it is nonetheless surprising that Mr King continues to sing the praises of a slumping pound.

Further evidence of a fall in the demand to hold money is provided by Investment Management Association figures showing £2.2 billion of net retail sales of unit trusts and OEICs in August, a record for the month – see chart. Sales remain on course to reach £24 billion in 2009, above the 2000 peak of £18 billion and up from just £4 billion last year.

As previously explained, if this year’s increase is a reflection of reduced money demand, broad money numbers will understate the growth in cash available to support a recovery in the economy and markets by about £20 billion, equivalent to 1.3% of M4 excluding “intermediate other financial corporations”.

Sales of bond and equity funds were similar in August, at £742 million and £696 million respectively, while property inflows continued their recent revival, reaching £129 million – the highest since June 2007.

The April Budget signalled substantial fiscal tightening starting from next year, with cyclically-adjusted public sector net borrowing projected to fall from a peak of 9.8% of GDP in 2009-10 to 4.5% by 2013-14. The current political debate is less about the scale of adjustment required than how it will be achieved.

It is widely assumed that a deficit cut of this size will act as a major growth depressant. Comparable tightening in the mid 1990s, however, was associated with robust economic expansion. Cyclically-adjusted net borrowing fell from 5.4% of GDP in 1993-94 to 0.6% four years later, a decline only slightly smaller than the 5.3 percentage point projected reduction between 2009-10 and 2013-14. Yet GDP growth averaged 3.2% a year between 1994 and 1998 – see chart.

The lesson of the 1990s is that major fiscal tightening need not derail economic expansion providing it can be phased over several years. The risk is that markets will deny policy-makers the luxury of a slow pace of adjustment – a gilt-buyers’ strike could push yields sharply higher and force action to be accelerated, with larger negative economic consequences.

Such a scenario could develop but there is currently little sign of any funding constraint. The bond market vigilantes were run out of town years ago, to be replaced by pension fund actuaries and compliant central bankers.

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COMMENT:
AUTHOR: Neil Prothero
EMAIL:
IP: 194.129.61.10
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DATE: 09/25/2009 11:03:54 AM

Excellent blog Simon.
You state that "Comparable tightening in the mid 1990s was associated with robust economic expansion". This was certainly true, but my concern with regard to the impact of major fiscal tigthening in the coming years is that current economic conditions are far different from those in the last decade, when strong export growth helped to offset weaker domestic demand. The world is now emerging — in a highly unconvincing manner, in my view — from a severe "global" recession with significantly impaired financial markets. Where is the external demand going to come from to offset the fragile growth conditions at home? The US? Euro area? This seems highly unlikely given the economic problems both face. Some support will obviously come from Asia, helped by weaker sterling, but this will hardly be sufficient on its own to drive a robust or sustainable economic expansion.

(Apologies for the delay in publishing this comment – Ed)

Sterling’s effective rate index reached a nine-month high on 5 August, the day before the Bank of England’s announcement of a £50 billion expansion of its quantitative easing programme. It had fallen by 6.9% by last night’s close, with a further move lower this morning. The timing is unlikely to be coincidental. The Bank’s gilt-buying may be creating excess liquidity in the economy, helping to explain surging equity and prime property prices as well as the fall in the pound.

The suggestion that monetary conditions are over-expansionary may appear strange given recent sluggish growth in the Bank’s favoured broad money measure – 5% annualised between January and July. However, the velocity of circulation of money is probably rising in response to record low interest rates and reviving risk appetite so the current rate of expansion may be more than sufficient to support an economic recovery, implying an excess available to push up asset values, including the sterling price of foreign currencies.

A recovery in velocity is suggested by a recent shift of funds out of savings accounts into cash and accounts used for transaction purposes: “non-interest-bearing M1” – comprising cash and interest-free current accounts – rose by 46% annualised between January and July. Strong retail buying of unit trusts and OEICs is also consistent with a reduced demand to hold money – see earlier post.

Though the figures relate to the second quarter, today’s National Statistics release on institutional investment flows provides evidence that some of the liquidity created by the Bank’s gilt-buying is flowing overseas. Insurance companies, pension funds and trusts bought £13 billion of foreign shares and bonds last quarter – the highest since the third quarter of 2007.

With the economy recovering and inflation continuing to overshoot the Bank’s forecasts by an embarrassingly large margin, the case for a further extension of QE was already looking weak. Sterling’s slump adds to the reasons for caution and – if sustained – could lead markets to bring forward expectations for monetary tightening.

G7 broad money has slowed significantly this year, with an estimated rise of only 2% annualised in the six months to August – see first chart. A theme of recent posts is that this weakness is not of undue concern because the velocity of circulation is likely to be rebounding after a plunge in 2008 and early 2009. Expressed differently, the demand to hold cash has fallen in response to record low interest rates and reviving markets so weak monetary growth does not signal insufficient liquidity to support an economic recovery.

Prior posts have also noted that a rise in broad money velocity is likely to be associated with a shift of funds out of savings accounts into cash and accounts used for transactions, implying a pick-up in narrow money relative to broad money. Continued solid growth in G7 M1 – an estimated 7% annualised in the six months to August – is therefore reassuring.

The relationship between velocity and the ratio of narrow to broad money is demonstrated for the US in the second chart. Velocity is normally calculated using nominal GDP and money supply data for the same period but this ignores lags in the transmission mechanism; the measure in the chart divides GDP by M2 six months earlier. For narrow money, “non-interest-bearing M1” is used, comprising currency, traveller’s cheques and “demand deposits” – interest-free accounts with a cheque facility.

There is a clear pattern of changes in the narrow to broad money ratio leading swings in velocity. The ratio is currently growing at an annual rate of 10%, which is the fastest since 1992-93, when M2 velocity rose by 4-5% per annum. A similar increase over the coming year would imply a strong rebound in nominal GDP – even if M2 shows little growth.

UK net mortgage lending fell from £108 billion in 2007 to £40 billion last year and just £4 billion in the first seven months of 2009. In July alone, net lending turned negative for the first time in the history of monthly data extending back to 1986. This may, however, mark the trough, with mortgage approvals signalling a significant recovery.

Net lending is the difference between gross lending and repayments, which can be broken down into regular repayments, redemptions and other lump-sum payments. Net lending is unaffected by remortgaging activity, which boosts gross lending and redemptions by the same amount (assuming no change in the outstanding loan balance).

The chart compares gross lending minus redemptions with the sum of regular repayments and other lump-sum payments. These “other repayments” have been stable recently. The fall in net lending into negative territory in July reflected a further slump in gross lending rather than stepped-up repayments.

Gross lending minus redemptions, however, should recover significantly, judging from recent data on mortgage approvals, excluding remortgaging. Approvals have been climbing since late 2008 and their current level looks consistent with monthly lending of about £6 billion. With “other repayments” running at just below £4 billion, this suggests a revival in net lending to about £2 billion a month by late 2009.

US non-financial corporations’ financial surplus – the difference between their retained earnings and capital spending – rose to 1.1% of GDP in the second quarter, according to flow of funds accounts data released yesterday. Excluding the third and fourth quarters of 2005, which were distorted by a one-off repatriation of foreign profits to take advantage of temporary tax incentives, the surplus was the highest since the fourth quarter of 1960.

The further improvement last quarter reflected a combination of stronger profits, cuts in dividends and fixed investment and faster destocking.

On top of this surplus, corporations raised cash from equity transactions for the first time since the second quarter of 2002, i.e. new issuance exceeded share buy-backs and retirements due to cash take-overs. Meanwhile, bond issuance remained heavy, though down from the record first-quarter pace.

Strong internal cash generation combined with capital market issuance allowed firms to increase their holdings of liquid assets and pay down short-term debt. The ratio of the two therefore rose sharply to its highest level since the end of 2006, supporting hopes of a strong recovery in capital spending – see first chart.

Some commentators have interpreted the recent contraction of bank lending to companies as supply-driven and likely to curtail business expansion. The comprehensive view of corporate finances provided by the flow of funds accounts suggests that bank debt repayment has been voluntary, reflecting the financial surplus and borrowing opportunities in credit markets.

The yield spread of non-investment-grade corporate bonds over Treasuries is inversely related, with a lag, to the sum of the financial surplus and net equity issuance, expressed as a percentage of GDP. The latter last quarter reached its highest level since the second quarter of 1958, suggesting scope for further spread compression – second chart.

Posts in early and mid April suggested that G7 industrial output would recover more strongly than forecast by the IMF and consensus. This was based partly on the “Zarnowitz rule” that “deep recessions are almost always followed by steep recoveries”.

US business cycle history provides some guidance about the possible speed of a Zarnowitz-style recovery. There have been eight falls in US industrial output of 13% or more since 1890. In six of the eight cases, output regained its prior peak level within 21 months of the trough. The exceptions were the recoveries after the 1929-32 slump – when output plunged by 54% – and the 1944-46 recession, when the economy needed to restructure away from armaments production.

In the recent recession G7 industrial output fell by 19% over 13 months to a trough in March 2009. (The March trough had been signalled by monetary data in late 2008.) Based on the US evidence, discounting the post 1932 and 1946 recoveries, output could regain its peak level within 21 months, i.e. by December 2010. This would imply annualised growth of about 13% during the recovery.

The chart compares the actual rise in output since the March trough with this “Zarnowitz” forecast and an alternative 2% growth scenario. 2% is the maximum likely to be consistent with the IMF’s latest published forecast of GDP expansion in advanced economies of only 0.6% in 2010. The last data point, for August, is an estimate based on US data released yesterday and a METI survey forecast for Japanese output.

Output is tracking slightly below the Zarnowitz path but is recovering much faster than forecast by the IMF and consensus. Based on the August estimate, the growth rate in the five months since the March trough has been 10% annualised.

Leading indicators suggest an acceleraton into the autumn, possibly closing the gap with the Zarnowitz forecast. For example, the OECD’s G7 leading index, which is designed to predict industrial output, rose by 18% annualised in the three months to July.

Investors are debating whether the pick-up will be sustained into 2010. With the boost from the stocks cycle still at an early stage and financial market conditions improving, an optimistic view remains warranted but this requires confirmation over coming months from a stabilisation of labour markets and continued monetary expansion.

The three-month change in the stock of job vacancies returned to positive territory in August for the first time since March last year. Vacancies are a good coincident indicator and the 2% gain is historically consistent with quarterly GDP expansion of the order of 0.5% – see first chart.

The recovery in vacancies, as well as the prior plunge, was signalled in advance by the Markit job placements index. The Market index climbed further to a 17-month high in August, suggesting the vacancies rise will gather pace – second chart.

The MPC claims that a Bank rate of 0.5% is necessary to prevent inflation from undershooting the 2% target over the medium term. Its recent forecasting performance, however, casts doubt on its ability to predict near-term inflation movements, let alone developments two years or more ahead. If the Bank’s inflation model is broken, it is fair to ask whether the pseudo-science of the Inflation Report fan charts should be ditched in favour of an ECB-style judgemental approach, including increased emphasis on monetary analysis.

In its February Inflation Report, the MPC predicted that annual CPI inflation would fall to 0.8% and 0.7% respectively in third and fourth quarters of 2009. A post at the time argued that this was too optimistic, with the Bank underestimating the inflationary impact of sterling’s plunge during 2008.

Despite upside surprises in early 2009, the Bank actually revised down its third and fourth quarter modal projections in the May Inflation Report, to 0.7% and 0.4% respectively. Further disappointing outcomes, however, forced a significant change in the August Report, with the forecast raised to 1.3% for both quarters.

Two months of data later, this no longer looks credible. With today’s 1.6% August result following 1.8% in July, inflation would have to plunge to 0.6% in September to average 1.3% in third quarter, as projected. The overshoot is likely to carry over to the fourth quarter. Bank of England Governor Mervyn King is probably now regretting his statement at the August Inflation Report press conference that a fall below 1% was “more likely than not” later in 2009.

A puzzle for the Bank’s forecasters is that core inflation remains sticky despite a weakening of import price pressures as sterling has rebounded this year – manufactured import costs fell by 5% between March and July, following a 14% surge in the prior 12 months. The CPI excluding energy, food, tobacco and alcohol rose an annual 1.8% in August and would probably have climbed 2.4-2.5% in the absence of December’s VAT cut (based on a National Statistics estimate that the reduction lowered headline inflation by about 0.5 percentage points). This would be the highest in its 12-year history – see chart.

As well as the size and persistence of the exchange rate effect, the lack of response of core trends to rising economic slack is troubling for the MPC’s inflation optimism. This could reflect longer-than-expected lags but the Bank’s forecasts may have placed overreliance on highly-uncertain estimates of the size of the “output gap” and its influence on pricing decisions.

The 1.6% August headline rate is in line with the inflation profile forecast presented in a previous post, although the breakdown is slightly different, with core prices higher and food prices lower than assumed. Updating inputs to take account of recent information, CPI inflation is projected to fall to 1.2% in September as a result of favourable base effects before rebounding to about 3% in January as VAT is raised back to 17.5%. The implied first-quarter average of 2.75% compares with a forecast of 2.1% in the August Inflation Report.

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COMMENT:
AUTHOR: S CURRIE
EMAIL: S_CURRIE@HOTMAIL.COM
IP: 94.194.3.37
URL:
DATE: 09/16/2009 11:10:16 AM

With inflation running higher than BOE forecast by the 1st qtr 2010 and QE ending shortly ,what price/yield on UK conventional gilts ?

(Apologies for the delay in publishing this comment – Ed)