Simon Ward - Money Moves Markets

Global recovery on track but momentum peak approaching

Simon Ward — Fri, 12 Mar 2010 11:35:18 +0000

Combined industrial output in the Group of Seven (G7) major economies and seven large emerging economies (the "E7", defined here to include Brazil, China, India, Russia, Korea, Taiwan and Mexico) rose by a further 0.8% in January to stand 10.9% above its trough reached in February 2009. Following a 13.6% drop during the recession, output is now only 4.2% below the peak reached in February 2008.

The recovery has been led by the E7 – output has risen by 19.1% from a low in January last year and is 8.8% above its pre-recession peak. G7 production, by contrast, has recovered by 8.3% from a March 2009 trough and is still 12.9% below peak. Relative performance improved in January, however, with a 1.4% gain versus flat E7 output, reflecting a sharp fall in Russia.

The recession and recovery in G7 plus E7 output continues to track closely G7 performance during and after the mid 1970s first oil shock downturn. This template suggests a sustained economic upswing but with momentum slowing during the second half of 2010 and into 2011 – see first chart.

The interpretation here is that recent monetary developments are consistent with this template. G7 real broad money is contracting on an annual basis but this is unlikely to signal insufficient liquidity to support an ongoing economic recovery because of a fall in household and institutional money demand due to negative real interest rates. Corporate liquidity – a key driver of the business cycle – continues to improve while narrow money M1 is rising solidly. Real M1 expansion, however, has moderated, suggesting slower economic growth later in 2010 – second chart.

Will markets force BoE tightening?

Simon Ward — Wed, 10 Mar 2010 15:45:52 +0000

The surprisingly dovish February Inflation Report suggested a shift in the Bank of England's priorities towards supporting growth in the face of coming fiscal tightening rather than achieving its formal remit target of a 2% annual CPI increase "at all times". The Bank, of course, justified its stance by projecting a future fall in inflation but its forecasts have little credibility, having been overshot persistently in recent years.

Markets, it appears, agree that the Bank's inflation-fighting commitment has softened. The yield gap between conventional and index-linked gilts of between five and 15 years' maturity – a proxy for long-term market inflation expectations – has risen steadily from a short-term low the day after the Inflation Report, yesterday reaching its highest level since October 2008. US market-implied inflation expectations are little changed over the same period – see first chart.

Sterling, meanwhile, has fallen by 4% both against the US dollar and in trade-weighted terms since the Report. Coupled with renewed strength in dollar commodity prices, this has resulted in an 11% surge in industrial raw material costs, as measured by the Journal of Commerce index in sterling terms – second chart. Input costs are 60% higher than a year ago.

The Bank is now in a bind. Markets are rebelling against its dovish shift and their reaction further increases the risk of a sustained inflation overshoot, warranting consideration of an early Bank rate hike. This would be highly contentious given the imminent election and weather-depressed economic reports but policy inaction could result in an extension of recent market moves, ultimately forcing the Bank's hand.

Promising labour market indicators

Simon Ward — Wed, 10 Mar 2010 10:40:51 +0000

The view expressed in prior posts that the global economic recovery will be sustained through 2010 rests on improvements in corporate liquidity feeding through to a pick-up in business investment and hiring, with rising employment supporting consumer incomes and spending. Recent US and UK evidence is consistent with firming labour demand.

In the US, non-farm payrolls fell by 171,000 in the three months to February but last month's number was depressed by snow storms that prevented some existing employees and new hires from turning up for work. An alternative payrolls measure based on households' assessment of their employment status is likely to have been less distorted by weather effects and rose by 292,000 over the last three months – see first chart. A catch-up gain in headline payrolls is possible this month.

Leading indicators have improved further: a measure based on the ISM manufacturing employment index, the NFIB small firm hiring plans index and the Challenger-Gray-Christmas lay-offs tally has risen to a level historically consistent with three-month payrolls growth of between 250,000 and 500,000 – second chart.

In the UK, job vacancies rose by a surprisingly-strong 11% in the three months to January from the prior three months, a pick-up confirmed by the Market jobs survey – third chart. Vacancies correlate with GDP so this suggests that underlying economic momentum, abstracting from weather effects, strengthened around year-end – final chart.

UK velocity rise threatens sustained inflation overshoot

Simon Ward — Tue, 09 Mar 2010 10:23:30 +0000

Current low monetary growth will not prevent inflation overshooting the 2% target because the velocity of circulation of money is rising fast in response to negative real interest rates. The Bank of England should raise interest rates to stem the fall in the demand to hold money and slow the pick-up in velocity.

Nominal GDP rose at an annualised rate of 3.9% during the second half of 2009 while the broad money supply – as measured by M4 excluding money holdings of non-bank financial intermediaries – fell by an annualised 1.2%. The velocity of circulation of money, therefore, increased by an annualised 5.1% – the largest two-quarter gain since 1999.

The velocity rise is the counterpart of a reduction in the demand to hold money by households and financial institutions, driven partly by a recovery in confidence but more importantly by the negative post-tax real return on bank deposits, which is encouraging a rebalancing of portfolios. Record mutual fund inflows are evidence of this portfolio shift: retail investors bought a net £1.8 billion of unit trusts and OEICs in January, bringing the 12-month running total to £26.4 billion, equivalent to 2.7% of household money holdings, according to Investment Management Association figures released yesterday – see chart.

Post-tax real interest rates were last negative for a sustained period in the 1970s. M4 velocity rose at an average annualised rate of 4.7% over 1974-79.

The 2% inflation target is consistent with nominal GDP growth of 4-5% per annum over the medium term, assuming trend real economic expansion of about 2.5% pa. If velocity were to continue to rise by about 5% pa, this would imply no room for any increase in the money supply. A policy of expanding asset purchases to achieve a positive rate of monetary growth would be misguided, leading to an inflation overshoot.

M4 excluding intermediaries’ money holdings rose by an annualised 1.9% in the three months to January. On current velocity trends, therefore, money growth may already be too strong to achieve the 2% inflation target. Rather than expanding asset purchases, the Bank of England should be considering raising interest rates to stem the flow of funds out of bank deposits and restrain the pick-up in velocity.

UK refinancing risk boosted by QE

Simon Ward — Mon, 08 Mar 2010 15:37:37 +0000

UK government debt has a longer average maturity than the international norm. Official figures, however, overstate the advantage because they fail to account for the "maturity transformation" implied by the Bank of England's gilt-buying.

According to the Debt Management Office (DMO), the average maturity of gilts and Treasury bills outstanding was 13.5 years at the end of 2009. This figure, however, includes £190 billion of gilts bought by the Bank of England, representing 23% of the stock of debt held outside the DMO.

The market has, in effect, exchanged these gilts, with an average maturity of about 10 years, for central bank reserves, which are repayable on demand. The relevant metric for assessing refinancing risk is the average maturity of the market's combined holdings of debt and reserves, not that of the stock of debt including the Bank's gilts. This is significantly lower, at about 11 years, down from 14 years in mid 2008 – see chart.

The Bank of England pays Bank rate on reserves. This results in an interest saving when Bank rate is below the initial yield on purchased gilts, as at present. The Bank, however, might be forced to tighten monetary policy aggressively in the event of a funding or exchange rate crisis. This would be instantly reflected in the combined government / Bank interest bill.

The UK's "true" debt maturity is still significantly longer than for other major countries – the US is at the low end of the range, with an average maturity of publicly-held marketable debt, including bills, of about four years. The gap, however, is much smaller than a year ago and would erode further if the Bank were to extend its gilt-buying programme.

Labour's window of opportunity: update

Simon Ward — Mon, 08 Mar 2010 08:50:56 +0000

An ICM poll published over the weekend reported a rise in the Conservative lead over Labour to nine percentage points from seven points in mid February, against the recent trend. This has not been confirmed by other pollsters – BPIX reported a further narrowing to just two points – but is consistent with the prediction of the economic polling model discussed in prior posts, beginning in December.

In this model, the governing party’s poll position relative to the main opposition depends positively on wage and house price growth and negatively on inflation, unemployment and interest rate changes. The model predicted a big narrowing of the poll gap in late 2009 and early 2010 but has been suggesting that the Conservatives would pull ahead again into the spring, mainly reflecting the negative impact of higher inflation on Labour’s popularity. A caveat, however, was that voters might blame the Bank of England rather than the government for faster price rises.

The approach, of course, can be criticised as reductionist and the model’s historical fit is far from perfect. It will, however, be interesting to monitor poll developments against its forecast of a widening of the Conservative / Labour lead to 11-12 percentage points in May (based on a rise in retail price inflation to 4.5% by March and stability of the other inputs).

If the model is to be believed, a Conservative majority is likely and Labour will rue not calling an early March election.

Are markets complacent about Ireland?

Simon Ward — Fri, 05 Mar 2010 11:54:26 +0000

Irish 10-year gilts are currently trading on a yield spread of 150 basis points (bp) over Bunds, down from a peak of 270 bp a year ago and compared with 300 bp for Greek bonds. This seems modest compensation for the financial risks. Irish and Greek spreads were similar as recently as November.

Ireland gained plaudits for a tough December Budget that cut the projected 2010 general government deficit from 13.5% of GDP to 11.6%. Following the further measures announced this week, however, Greek plans are more ambitious, targeting a budget shortfall of 8.7% of GDP this year.

Ireland’s stability programme envisages a decline in the deficit to 2.9% of GDP by 2014, a reduction of 8.7 percentage points over four years. This looks impressive but assumes €5.5 billion of unspecified future fiscal retrenchment. On current policies, the 2014 deficit would be 5.6% of GDP. This compares with UK general government borrowing of 4.6% of GDP in 2014-15 projected in December’s Pre-Budget Report.

Within general government, the Exchequer or central government deficit is projected to decline by 26% in 2010. The shortfall in January and February, however, was 15% higher than a year before. Current spending fell by 5% but current receipts were down by 18%. Ireland is lagging the global recovery – the OECD’s leading index is up by 3% over the last 12 months compared with gains of 10% and 9% for its Eurozone and UK indices. With the UK accounting for more than a fifth of trade, recent sterling weakness against the euro is unwelcome.

Ireland’s banking system is critically dependent on ECB life support. Central Bank of Ireland lending to banks was €98 billion at the end of January, the equivalent of 60% of annual GDP. This represents 13% of total Eurosystem lending to banks compared with Ireland's 2% share of Eurozone GDP. The Bank of Greece's lending to banks amounts to 20% of Greek GDP while numbers for Spain and Portugal are much lower – see previous post.

A renewal of market worries about Ireland would be expected to be reflected in a withdrawal of funds from its banking system, necessitating increased ECB support. Irish central bank lending is down from a peak of €130 billion in June 2009 but rose in December and January. This bears monitoring: an increase in lending in mid 2008 preceded a sharp rise in the Irish / German yield spread – see chart.

Is "inflation targeting lite" contributing to sterling weakness?

Simon Ward — Wed, 03 Mar 2010 10:32:00 +0000

The “MPC-ometer", discussed in numerous posts between 2007 and early 2009, is designed to predict monthly Monetary Policy Committee decisions based on incoming economic and financial data. The model suggests that policy tightening will soon be necessary, barring new “shocks”. This contrasts with the message of the February Inflation Report but news may force the MPC to execute a swift U-turn. An attempt to maintain inappropriately loose policy settings could accelerate sterling’s slide, further undermining the credibility of the Report's forecast of lower inflation.

The MPC-ometer is designed to predict the weighted-average interest rate vote of the Committee’s members. For example, if five want to raise official rates by 25 basis points (bp) while four prefer no change, the weighted-average vote is +14 bp (five-ninths of 25). If it is assumed that votes are either for no change or a move of 25 bp – reasonable under “normal” economic and financial conditions – then the model forecasts an actual rate change when the weighted-average prediction is greater than +12.5 or less than -12.5 bp. Introduced in September 2006, the MPC-ometer performed well over the subsequent two and a half years, correctly signalling the month and direction of 12 out of 13 rate movements – two more than the mean economists’ forecast from the monthly Reuters poll.

The MPC-ometer’s 12 inputs were selected on the basis of statistical analysis and can be grouped into indicators of economic activity, inflation and financial market conditions. The inflation sub-set is largest, comprising the latest headline annual increases in consumer prices and average earnings as well as several measures of expectations. Activity indicators include GDP growth and business / consumer confidence while credit spreads and movements in share prices and the exchange rate are used to gauge financial conditions.

A review of its forecasts during the period of unchanged rates since last March indicates that the MPC-ometer has continued to provide guidance about policy decisions. Specifically, it predicted further easing moves in May and August, months in which the MPC announced a £50 billion expansion of asset-buying plans. The model suggests that the MPC regards £50 billion of additional purchases as equivalent to a reduction in Bank rate of about 17 bp. On this basis, the £200 billion programme has substituted for a further rate cut of about 70 bp.

The weighted-average interest rate vote forecast by the model was negative between April and November last year, consistent with a residual easing bias. It rose, however, to +3 bp in December and +10 bp in January before falling back to +2 bp in February in response to preliminary figures showing GDP growth of only 0.1% in the fourth quarter. The forecast has rebounded to +12 bp in March, reflecting higher inflation, further gains in business and consumer confidence – both now well above long-run average levels – and upwardly-revised GDP expansion of 0.3% last quarter.

The MPC-ometer suggests, therefore, that as many as four members will vote to tighten policy this week. The February Inflation Report and more recent MPC communications indicate that such an outcome is highly unlikely. The current divergence between the model's forecast and MPC behaviour raises three possibilities.

First, the model may be signalling an imminent shift in the Committee's thinking. It has sometimes been "early" historically. Economic news and market developments since the Report was prepared have weakened the case for retaining an easing bias and may have emboldened members concerned about excessive policy laxity.

Secondly, the model may simply have broken down. Estimated on data since the MPC's inception in 1997, it may be failing to capture the full range of influences on monetary policy in the wake of a deep recession. This argument, however, is weakened by the similarity of the model's prediction and the latest vote of the Sunday Times Shadow MPC, which also has a good forecasting record. Three Shadow MPC members voted to raise Bank rate by half a percentage point this month – see David Smith's blog for the minutes.

This leads on to the third possibility, which is that the MPC's historical reaction function, rather than the MPC-ometer, has broken down. The Committee has, in effect, shifted to "inflation targeting lite", downplaying the requirement of its remit to achieve the 2% inflation target, defined by the consumer price index without exclusions, "at all times" in favour of supporting an economic recovery and promoting fiscal tightening by promising a monetary-policy "pay-off". Market suspicions of such a shift may be contributing to current sterling weakness.

UK recession, ex oil, less severe than 1979-81

Simon Ward — Tue, 02 Mar 2010 13:48:13 +0000

GDP fell by 6.2% between the first quarter of 2008 and the third quarter of 2009 before recovering in the fourth quarter. The drop exceeds the peak-to-trough decline of 6.0% during the 1979-81 recession.

The recent GDP reduction, however, was magnified by a large fall in oil and gas production, reflecting reserves depletion. Oil output rose during the 1979-81 recession, when the North Sea was coming on stream.

With North Sea production driven by supply capacity rather than domestic or global demand, it may be more appropriate to focus on non-oil output when comparing economic weakness across cycles.

On this basis, the recent recession was less severe than 1979-81: the peak-to-trough fall in non-oil "gross value added" is currently estimated at 5.8% versus 6.4% – see chart.

UK monetary conditions too loose despite weak M4

Simon Ward — Mon, 01 Mar 2010 11:59:28 +0000

Broad money trends remain weak: M4 excluding money holdings of non-bank financial intermediaries was unchanged in January and has contracted at a 1.9% annualised rate over the last six months. This weakness, however, is compatible with both a solid economic recovery and inflation overshooting the 2% target.

The key monetary driver of the business cycle is the corporate liquidity ratio – companies' money holdings divided by their bank borrowings. This ratio is a major influence on firms' decisions about capital spending and employment, with the latter driving household income and, in turn, demand. In contrast to aggregate broad money, corporate M4 rose by an annualised 4.6% in the six months to January.

The corporate liquidity ratio forewarned of the recession in 2007 at a time when aggregate money and credit were still rising strongly. It reached a low in early 2009 and has recovered significantly, suggesting an imminent pick-up in business spending and hiring. Excluding the struggling real estate sector, the ratio is above its average level since the late 1990s – see chart.

Firms have been able to rebuild their liquidity despite weak aggregate M4 growth because of a fall in the demand to hold money by households and institutional investors. This partly reflects a revival in confidence in markets; in addition, the negative real post-tax return on bank deposits may be triggering a major rebalancing of portfolios.

The current monetary environment resembles the aftermath of the 1974-75 recession. GDP rose by 6% in the first two years of the subsequent recovery despite a 6% contraction in the real broad money stock. The corporate liquidity ratio increased strongly before this upswing as household and institutional money demand fell in response to negative real interest rates. Inflation accelerated as the recovery developed.

The 1976 sterling crisis was caused partly by fiscal laxity – public sector net borrowing reached 7.0% of GDP in 1975-76 – but monetary policy was also too loose, with interest rates held below inflation and the deficit financed largely through the banking system. Current Bank of England policy is identical to that pursued by the monetary authorities in 1975-76 and carries a significant risk of similarly inflationary consequences.