Category: Money Moves Markets

The MPC-ometer is designed to predict the outcome of each month’s MPC meeting based on incoming economic news and financial market developments. It forecasts no change in either Bank rate or quantitative easing plans at today’s meeting.

The balance of news over the last month is judged to be neutral. Growth and financial market indicators have improved: business surveys are stronger, the stock market has rallied further and interbank interest rates have fallen. Inflation indicators, however, have weakened, with the headline CPI increase slowing sharply and first-quarter average earnings down by 0.1% from a year earlier.

The MPC last month expanded its quantitative easing programme to £125 billion, implying that Bank of England asset purchases will continue until the end of July. QE is intended to boost money supply growth. The latest monetary statistics suggest that the policy is working. A decision about a further extension will probably be deferred until next month’s meeting.

The MPC’s favoured money supply measure – broad money M4 excluding cash holdings of financial intermediaries – is estimated to have risen by a chunky 1.0% in April. Growth has been running at a 7.8% annualised rate so far in 2009, up from just 3.0% during the second half of last year.

QE works by boosting investors’ cash holdings, thereby encouraging them to buy private-sector securities. This raises asset prices and makes it easier for companies to float new equity and bond issues. Corporations raised £13.6 billion from sterling capital issues in the three months to April, up from just £3.8 billion in the previous three months.

Stronger monetary growth supports hopes that the economy will stabilise soon. The recent pick-up, however, needs to be sustained to lay the foundations for an economic recovery in late 2009 and 2010.

Most commentators appear to have missed the big story in yesterday’s monetary data – the 1.0% rise in the Bank of England’s adjusted M4 proxy in April (see previous post). Reports focused instead on the 0.1% monthly contraction in bank lending to households and non-financial corporations. According to the consensus, the lending decline is evidence of a continuing credit crunch and signals further economic weakness.

Three points are worth emphasising. First, empirical analysis shows that money leads the economy whereas credit lags. This is why the US Conference Board includes the real M2 money supply in its index of leading indicators, while real commercial and industrial loans and the ratio of consumer credit to personal disposable income are components of its lagging index.

Secondly, credit trends are nonetheless important to the extent that they influence monetary growth. The MPC, however, has correctly chosen to offset the monetary impact of credit weakness by buying gilts. This policy should and presumably will continue until credit growth revives and resumes its normal role as key driver of monetary expansion.

Thirdly, it is impossible to disentangle supply and demand effects on credit trends. Recent weakness may have been demand-led, reflecting a reduced need for working capital as stocks are run down together with companies taking advantage of more favourable market conditions to float new issues, using the proceeds to repay bank debt.

The adjusted M4 proxy is volatile and it would be unwise to read too much into a single month’s increase. The MPC, however, should be reassured by the faster pace of growth so far this year, suggesting that a decision about expanding the QE programme further will be deferred until next month’s meeting.

Two Group of Seven (G7) countries have released April industrial output figures: the US registered a 0.5% decline and Japan a 5.2% gain – see first chart. The Japanese rise dominates and suggests a small increase in G7-wide output in April barring significant weakness in European data due in a fortnight’s time.

G7 output peaked in February 2008. A bottom in March 2009 would imply a 13-month recession, similar to the duration of the 1974-75 and 2000-01 downturns (12 and 11 months respectively) – second chart. The recent fall, of course, has been much larger, with a 19% peak-to-trough drop versus 12% in 1974-75 and 7% in 2000-01.

A post last December predicted a G7 output bottom in March based on a pick-up in inflation-adjusted narrow money M1. Real M1 is showing very strong annual growth, supporting near-term economic recovery hopes – third chart. It has, however, slowed over the last three months – further weakness could signal a loss of economic momentum in late 2009.

With a 0.1% fall in consumer prices in the year to May, Germany becomes the fourth Group of Seven (G7) country to record headline “deflation”, following the US, Japan and the UK (the latter based charitably on the retail prices index, which incorporates declines in mortgage rates and house prices, as well as the December VAT cut).

G7-wide consumer prices were down an annual 0.3% in April. The fall reflects a collapse in commodity prices from their levels a year ago – see chart. The rate of change of “core” CPI – excluding food and energy – remains positive in every country bar Japan, averaging an annual 1.5%. As the chart shows, the commodity price effect will reverse in late 2009, assuming no renewed decline from current levels.

Headline inflation should therefore converge on core. Core inflation should decline in 2009-10 as global excess capacity undermines pricing power. After the last recession it fell to an annual 1.0%. Headline G7 inflation could rebound to around this level in early 2010 – higher if commodity prices continue to rally.

Deflation, like inflation, is a monetary phenomenon. The global money supply continues to grow healthily, arguing against a sustained period of falling prices.

Today’s Financial Times draws attention to the huge deterioration in the UK’s relative inflation performance caused by last year’s plunge in the exchange rate, a topic discussed in an earlier post. Its observations, however, should be qualified in two respects.

First, the FT uses the CPI excluding indirect taxes as a gauge of “true” inflation, i.e. adjusting for the impact of December’s VAT cut. This rose an annual 3.8% in April versus a 2.3% increase in the headline CPI. A better measure, however, is the CPI at constant tax rates (CPI-CT), which climbed by a smaller 3.4%.

Moreover, both of these alternative indices are based on the assumption that the VAT reduction was passed on in full – highly unlikely. Using a more realistic estimate of 50% pass-through, “true” inflation in April was 2.8-2.9% (i.e. halfway between the headline 2.3% and 3.4% CPI-CT increases).

Secondly, as discussed in a post last week, recent sterling strength – if sustained – promises a reduction in imported inflationary pressures later in 2009. The MPC’s central-case forecast that the annual CPI increase will slow to 0.4% by the fourth quarter looks much too optimistic but the gap between UK and US / Eurozone inflation is peaking and should narrow significantly.

For the gilt market, supply is likely to represent a greater threat than relatively high UK inflation. The stock of gilts in market hands should shrink by about £50 billion over March-July, with Bank of England purchases of £120 billion offsetting net issuance of £70 billion. If the MPC were to suspend QE purchases from August, however, the market would need to absorb supply of £130-135 billion in the final eight months of 2009-10. (The DMO plans to issue a net £203 billion this fiscal year, based on the Treasury’s forecast of public net borrowing of £175 billion.)

In other news today, minutes of this month’s MPC meeting show that that some members favoured expanding QE by £75 billion rather than £50 billion, while the Committee discussed writing a letter to the Chancellor requesting an increase in the £150 billion limit “should economic conditions require it”. This is likely to fuel expectations that gilt-buying will be extended beyond early August but such a decision will depend importantly on forthcoming monetary data (provisional April broad money numbers are released tomorrow).

Meanwhile, Inflation Report forecast tables show that the MPC expects annual average GDP changes of -4.0% in 2009, 1.1% in 2010 and 2.7% in 2011 in its central case based on market interest rate assumptions. However, its mean projections – taking into account a negative risk skew – are much weaker, at -4.2%, -0.2% and 1.6% respectively. This looks excessively gloomy – see last post.

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COMMENT:
AUTHOR: Jonathan Purle
EMAIL: jp@intethic.com
IP: 81.130.114.169
URL: http://www.intethic.com
DATE: 05/21/2009 08:55:39 AM

Good morning Simon.Some of us feared that QE would lead to a bond bubble. Something similar occurred in Japan, even though BoJ focussed on purchasing securities directly from Banks and there was little seemingly direct impact on broad money (M2+CDs). Obviously the UK approach of buying gilts and bonds from the non-Bank sectors would imply that this could be more pronounced. The arithmetic suggests the gilt market is being held up by QE purchases and will crash when this eventually ceases (unless the ‘independent BoE’ actually carries on monetising these huge deficits for ever and a day).

– Do we have a gilt bubble? Or to what extent do you think the market is discounting the end of QE?

– To what extent do you believe QE is holding up the market in investment-grade bonds? There is little direct purchasing by BoE going on – a fraction of what was originally proposed…

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COMMENT:
AUTHOR: Simon Ward
DATE: 05/22/2009 05:25:53 PM

Thank you for your comments. On your second question, QE has probably had more impact on corporate bonds than the low level of Bank purchases would suggest, as cash injected via gilt-buying finds other homes. However, the rally appears mainly to have reflected global factors. It would be surprising if spreads widened significantly when QE ends.

It seems difficult to argue that QE has caused a gilt bubble – yields have reversed their initial decline remarkably quickly. To the extent that there was / is a bubble, it reflects excessive gloom on economic prospects and complacency on inflation, rather than QE. However, I share your concern that the market is not fully prepared for the scale of the coming swing from net official purchases to sales.

A monthly GDP estimate derived from data on services and industrial output fell by 0.2% between February and March, the smallest decline since October – see chart. The slower pace of contraction is consistent with better purchasing managers’ survey results in March; PMI readings continued to improve in April.

The monthly estimate was 0.3% below its first-quarter average level in March, suggesting that second-quarter GDP figures – released in late July – will show a further decline. Based on current PMI readings, however, this could be smaller than the 0.6% fall implied by the Bank of England’s latest Inflation Report forecast. The Bank is projecting a further contraction of 0.3-0.4% in the third quarter.

Today’s numbers confirm a 1.9% GDP fall between the fourth and first quarters, with the expenditure breakdown showing broad-based weakness. A silver lining, however, is that destocking rose further to reach 2.0% of the level of GDP – the highest on record in quarterly data going back to 1955. A slowdown in stock liquidation will provide important support to the economy later in 2009.

Provisional April monetary statistics released today do not include new information on the MPC’s favoured broad money aggregate – M4 excluding deposits of “intermediate other financial corporations”. On the basis of the data provided, however, this measure is likely to have grown moderately last month.

Headline M4 rose by just 0.1% in April but the release notes a negative impact from a fall in repos with “other financial corporations”. To the extent that this decline reflected transactions with financial intermediaries, it will not affect the MPC’s adjusted M4 measure. Without the repo change, M4 would have grown by 0.5% last month, or about 6% annualised.

The Bank of England’s gilt purchases were reflected in a large public sector contribution to M4 growth in April – “net sterling lending to the public sector” amounted to £30 billion or 1.5% of M4. This boost, however, was partly offset by weakness in private sector sterling credit and a large fall in “net other assets”.

Overall, the figures – while incomplete – are slightly disappointing and support the MPC’s decision to expand the QE programme.

The recession probability indicator discussed in earlier posts signals that the UK economy will return to growth by early 2010. The indicator is less gloomy than the latest Bank of England Inflation Report and suggests that the Treasury’s forecast of a 1.25% rise in GDP in 2010 is achievable. However, a full recovery – in the sense of trend economic growth or higher – will require faster monetary expansion.

The indicator estimates the probability of the economy being in a recession three quarters ahead based on a range of monetary and financial inputs, including inflation-adjusted broad and narrow money supply growth, companies’ liquidity ratio, three-month LIBOR, the yield spread between corporate and government bonds, share prices and the effective exchange rate. A recession is defined as an annual fall in GDP – a stricter interpretation than often employed.

The recession probability estimate began to climb in the second half of 2007 and reached a peak of 91% at the end of 2008 in the wake of Lehman’s collapse – see chart. It fell back to 71% in the first quarter of 2009, however, and a further decline to 33% is indicated for the second quarter, using the latest values for the inputs.

Allowing for the nine-month lead, therefore, the indicator suggests a two-thirds chance that annual GDP growth will be positive in the first quarter of 2010. In other words, any further near-term decline in output is likely to be recouped in late 2009 and / or early 2010. By contrast, the latest Inflation Report fan chart appears to imply only a 40% chance of positive annual growth in the first quarter of 2010 (precise figures will be available tomorrow).

The indicator’s output can also be expressed as a mean forecast for annual GDP growth three quarters ahead. Based on the latest input values, the forecast for the first quarter of 2010 is 0.7%. The Treasury’s projection of 1.25% GDP growth for 2010 as a whole therefore appears reasonable, barring an economic relapse later next year.

The fall in the recession probability estimate has been driven by declines in short-term interest rates and the effective exchange rate and – more recently – firmer real money growth, a rally in share prices and narrower credit spreads. With little scope for short rates to move lower, however, and sterling finding a floor recently, further improvement is likely to depend on stronger monetary trends.

It would be surprising if the expanded £125 billion QE programme – equivalent to 8% of the adjusted M4 money supply – failed to produce a monetary pick-up. Provisional April broad money figures published on Thursday will provide more information on the impact of recent official gilt purchases.

The recent bear market in equities has been unusually severe. It has also been unusually short by the standards of previous big bears. This suggests that a period of base-building will be necessary before markets can embark on a sustained recovery.

The table compares the fall in the Dow Industrials between October 2007 and March 2009 with the seven biggest bear markets of the last century. The peak-to-trough decline of 54% exceeds every prior downturn except the depression bear of 1929-32, when prices slumped by 89%.

The falls in the six other bear markets ranged from 45% to 52%. Prices seem to find a floor after a decline of about a half. This was true even in the 1929-32 bear: after a 48% drop between September and November 1929, equities rallied by 48% before embarking on a further prolonged slide. A recovery from the levels plumbed in March this year was, therefore, predictable.

If the bear market ended in March, however, it will have been only 17 months in duration – five months less than the shortest of the twentieth century bears. This implies that there may be more work to do on the downside – in terms of time if not price – before a sustained advance can begin.

Some of the prior bear markets show little resemblance to the recent decline. The 1909-14 and 1937-42 downturns were influenced by world wars. A repeat of 1929-32 is unlikely – policy mistakes made in the early 1930s have so far been avoided.

The respected financial and economic analyst Tony Plummer argues that equities experience severe bear markets at the end of 30-year economic cycles. He suggests comparing the recent decline with the 1919-21 and 1973-74 bears, which also occurred around 30-year cycle troughs. (Equity market behaviour around the 30-year low in the 1940s was distorted by the war.)

There is also a case for comparing the recent decline with the 1906-07 bear, which was associated with a major financial panic and extreme banking system distress. As Plummer notes, the failure of the Knickerbocker Trust Company in October 1907 and the subsequent policy response, orchestrated by J P Morgan, contain many parallels with events surrounding Lehman’s bankruptcy last autumn.

These three bear markets (i.e. 1906-07, 1919-21 and 1973-74) bear a close resemblance, with equities declining by 45-49% over 22-23 months. The chart provides a comparison with the recent decline. Equities undershot the historical range in early 2009, probably reflecting fears of banking system nationalisation, but have since returned to a level consistent with the prior bears.

If these three earlier cycles are a guide, equities are unlikely to embark on a sustained advance before August / September. Until then, prices may consolidate their recent gains or – in a worst case scenario – retest the March lows. The 50% peak-to-trough barrier, however, provides important support.

The latest Inflation Report is downbeat and will douse recent hopes that the recession is nearing an end. The MPC is arguably too gloomy, particularly about the balance of risks to activity, and may be underestimating the potential boost to the economy from its expanded QE operation.

Key points:

• The central-case GDP forecast is significantly weaker than in February – see chart. This reflects both a lower-than-expected first-quarter outcome and a slower recovery in 2010-11, with the MPC more concerned about credit supply constraints than in February (odd given improvements in the last credit conditions survey).

• The central-case path – estimated from eyeballing the fan chart – implies further falls in GDP in the second and third quarters followed by marginal expansion in the fourth quarter and first quarter of 2010. Trend-like growth resumes in the second quarter of next year. GDP returns to its peak level only in early 2012 – a year later than in February.

• The central-case path is notably weaker than the Treasury’s Budget forecast. The fan chart implies annual average GDP changes of an estimated -3.9% this year, +1.0% in 2010 and +2.6% in 2011 versus the Treasury’s -3.5%, +1.25% and +3.5% respectively.

• Cleverly, however, the MPC has concealed the extent of its difference with the Chancellor by expressing its gloom partly in a negative risk skew to the central-case forecast. The mean projection, taking into account this skew, appears to be for GDP growth of only 0-0.25% in 2010 and 1.5-1.75% in 2011 – far below Mr. Darling’s assumptions.

• The MPC underestimated the inflationary impact of sterling’s plunge and has revised up its near-term CPI projections. The change, however, is modest: inflation averages an estimated 1.6% in 2009 in the central case versus 1.4% in February. Currency effects are judged to be offset by a wider margin of spare capacity and a larger fall in household energy tariffs than assumed in February.

• Longer-term inflation projections have also been revised higher but remain below 2% as far as the eye can see. The central-case forecast for the first quarter of 2012 is an estimated 1.6% versus 1.1% in February. The MPC may be lowballing the numbers in an effort to keep inflation expectations anchored against a backdrop of QE and fiscal profligacy.