UK monetary policy is being driven by the pound’s rise and Gilt yields

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Firstly welcome to 2014 to all readers of this blog as we enter yet another year of the credit crunch era. A bit like the First World War -whose centenary starts this year- its supposed end is always just around the corner on the “over by Christmas” theme but is then replaced by a much grimmer and longer reality. Already we are seeing some developments for the currency and bond or Gilt yields of the UK and it is the consequences of these which I intend to analyse and examine today.

The super soaraway pound

The paragraph heading which if I recall correctly was used some years ago by the Sun newspaper is apt as a description of the performance of the UK pound sterling since Mark Carney introduced the policy of Forward Guidance back on the 7th of August 2013. Symbolically the exchange rate against the US Dollar which is often used as a signal on its own closed at US $1.538 on the night before Forward Guidance was introduced and this morning has touched US $1.66 for a rise of nearly 8%. Oh how HSBC must rue predicting a sterling crisis in late spring when the pound diced with the US $1.50 level!

Even against the Euro or Deutschmark-lite the pound is making some progress as it pushes through the 1.20s. Against the plummeting Japanese Yen it has risen above 174 Yen and at one point tried to make 175 Yen today. At the close the night before Forward Guidance began, we were at 150 Yen to the pound so there has been a particularly strong move here.

If we sum up the position, the overall trade-weighted index is up by around 6% which on the rule of thumb for UK monetary conditions is considered equivalent to a 1.5% increase in base rates. This gives plenty of food for thought for the whole concept of Forward Guidance which lest we forget tells us this.

In particular, the MPC intends not to raise Bank Rate from its current level of 0.5% at least until the Labour Force Survey headline measure of the unemployment rate has fallen to a threshold of 7%,

So we see the impact of the concept behind Goodhart’s Law at play one more time. A policy objective and mechanism is declared but something happens to change it. Indeed in the credit crunch era neutralisation and even reversal have become quite common. We do not know what would otherwise have happened -the ceteris paribus concept- but we do know that a promise not to increase base rates has seen the currency rise by the equivalent of a 1.5% rise so far. On this road a loosening becomes a tightening and we are into my “dark side” view of UK monetary policy. It also means that this claim for Forward Guidance is both misleading and wrong.

Second, it reduces uncertainty about the future path of monetary policy as the economy recovers.

Lest we forget it was not so long ago that the value of the pound was much higher. The beginning of 2007 saw the pound at US $1.97, Euro 1.49 and 234 Yen and the doomsayers in the media right now about the current rise might like to consider how little good the fall from those levels actually did us. Yet again there is enormous theoretical asymmetry or if you prefer bias.

UK Gilt yields

The UK Gilt of government bond market has opened weakly in 2014 and the falls in price have seen the ten-year yield rise to 3.06%. This marks quite a change from a year ago when it was just below 2% and an even greater rise since the yield nadir and price peak of May when it dipped below 1.6% briefly. If we move to real yields then we face the prospect of an even larger move as consumer inflation has been falling recently such that if we use the Consumer Price Index the UK ten-year Gilt has a real yield approaching 1% and even with the Retail Price Index it is nearly 0.5%. It is some time since this particular measure has seen the prospect of real yields that are not negative as we add the caveat that future inflation over the next ten years is of course unknown. We do know that a rallying pound -especially against the US Dollar-should help in this respect.

This takes me back to a blog I wrote on September 7th 2011.

So I find myself disagreeing with the likes of Paul Krugman who feel that the level of bond interest rates means that you can borrow as much as you like with the implication that you can borrow for ever at such low rates. My opinion is that you can for a while but then it will not only be too late to change but your extra borrowing will make things worse.

Actually in many ways I was even more right when I carried on to say this.

The real problem is that it is very hard to predict when this will take place, but just because you cannot be exact about the timing does not mean that it will not happen.

For newer readers a theme of this blog has been that longer-term bond yields will turn  decisively higher. I am discussing in fact ultra long term matters here as for example they have been falling in the UK over my career. So such a trend change will be extremely significant as it is a mistake to only look at official headline short-term interest -rates. Whilst they rarely publicly admit this, central banks think so too as otherwise why have they indulged in bond purchases or yield suppression on such a large scale? Oh and named it something else -Quantitative Easing- to further put the unwary off the scent.

Back in September 2011 I wrote a section entitled humility and honesty which remains true. As a trend events have moved my way but on that path yields as I have described above did go lower first. It is ever thus with bubbles as they provide plenty of opportunities for humility even if you end up being correct…

An international perspective

It has become a mantra of the times to think that the peripheral Euro area countries have way higher government bond yields that the UK. But right now both Italy and Spain have ten-year bond yields of just over 4% so around 1% higher than the UK. We have moved substantially above the 2.58% of France so there has been a paradigm shift at play which does not often get an airing. Could we crossover with Ireland which is currently at 3.44% and which way would that take place?

Actually it might be more accurate to say that perhaps we are reversing a paradigm shift as if look back to the days before the Euro crisis these countries had lower and not higher bond yields than the UK.

What is driving this?

A powerful influence was highlighted by today’s business survey from the manufacturing purchasing managers.

On its current track, the sector should achieve output growth of over 1% in the final quarter while filling around 10-15 thousand jobs, continuing its positive contributions to both the broader economic and labour market recoveries.

There was an interesting addition to this as well.

UK exporters are also finding pockets of strength, with sales of capital and intermediate goods rising solidly to destinations such as Brazil, China, Ireland, Russia and the USA.

Let us hope that the price elasticity of UK exports is on the way up the same as it was on the way down.

Comment

Whilst the Bank of England is hyping a view similar to that of Sir Humphrey Appleby’s “masterly inaction” in fact it has simply moved the monetary tightening to other financial markets. Currency strength and bond yield rises have replaced a base rate move as central bankers continue their efforts to distort as many things as they possibly can! My “dark side” theory predicts an asymmetric response function where Mark Carney will take the credit if this works and blame financial markets if it does not. So for him, but not us it is a win-no lose game.

Thus the UK economy is seeing a welcome disinflationary push from the strength of the pound but also seeing deflationary pressure applied to our trading sector rather than our housing market. As Karl Marx put it.

History repeats itself, first as tragedy, second as farce.

Tucker’s Luck

There was much to consider in the awarding of a knighthood to Paul Tucker who until recently was a Deputy Governor of the Bank of England. If nothing else I wondered how in a country with a pensions lifetime allowance of £1.5 million a public servant could amass one valued at £5.7 million.

Apparently he has done an “outstanding job” and been an “enormous” success. If this has been success would somebody in authority please let us know what failure is? Oh and don’t mention Libor….

 

This entry was posted in Bank of England, Forward Guidance, General Economics, Gilts, Quantitative Easing and Extraordinary Monetary Measures, UK Inflation Prospects and Issues and tagged , , , . Bookmark the permalink.
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  • forbin

    Hello Shaun,

    ” Apparently he has done an “outstanding job” and been an “enormous”
    success. If this has been success would somebody in authority please let
    us know what failure is? ”

    Apparently its not walking off with large wads of cash being stuffed in your pockets

    Main stream continues to ignore this …… but then thats not really a surprise is it ?

    Forbin

  • Dave Holden

    Hi Shaun,

    Could you enlighten this non economist, why does an increasing pound equate to monetary tightening?

  • Anonymous

    Yup, I also don’t get how a rise in the value of the pound can equate to a rise in base rates? Is that also the monetary tightening that you speak of?

  • anteos

    Hi Shaun

    happy new year. Looking forward to more of your great articles.

    I’m pretty sure the public won’t enjoy the benefits of a strong pound (through disinflation), whilst government borrow costs are rising. I’m sure Carney will step up and trash the pound at some point.

    They’ll continue to blather on about forward guidance, but interest rates will not rise until they are forced to.

    I’ve been recently reading about citizens income, At the risk of being cheeky, would you consider writing an article about it?

    thanks in advance.

  • Drf

    Hi Shaun,
    “We have moved substantially above the 2.58% of France so there has been a
    paradigm shift at play which does not often get an airing.” But yesterday the French 10 year bond yield climbed around 4.5 basis points, so the present trend for them is also not good!

    See http://www.telegraph.co.uk/finance/economics/10546875/French-borrowing-costs-rising-at-worrying-rate.html “The ten-year bond yield climbed as much as 4.5 basis points on Wednesday as a
    gauge of activity in its manufacturing sector slipped to a seven month low,
    to the lowest of the eurozone’s major economies.”

    Interesting to see you are now agreeing that the term”QE” was coined to deceive the unwary (and unaware?).

  • Anonymous

    Shaun – Merv did the same thing when GBP dropped 20% because he was rubbish at his job. He came out with “cost push” and not a single mainstream journo questioned him on this.

    I think bond yields are *the* issue. Do you think that if the US improves and their borrowing costs rise the UK will be dragged along? In this case would the UK start to print more and more via QE to purchase all bonds, which would then lead to a collapse of confidence? I really don’t see how we can allow 2/10 year to rise as mortgage costs would go through the roof and this would damage the UK “economy” massively.

    It’s always been my view that the UK’s malaise was blunted by the US recession and if the US improves we will see the UK is in fact in a depression. I think the UK establishment will QE forever so long as they can get away with it, but a US recovery would “let the light in on the magic”.

  • Anonymous

    Could they have made a more technical name! It’s up there with flux capacitor in Back To the Future!

    The most sickening one is Help2Buy. They really must have laughed when someone suggested it but then Osborne would have seen that bold is best and a joke became reality.

  • Anonymous

    Hi Forbin

    Actually across places such as the twitter sphere Paul Tucker did acquire some praise for his work on the credit crunch. They were less clear about whether that involved contributing to creating it ! After all he joined the MPC in 2002.

    I doubt many bothered to check the value of his pension which is not that hard to find. After all if you do it is impossible not to then think what value for money that is was for the UK taxpayer….

  • Anonymous

    Hi Dave and indeed White P

    A rise in an exchange rate has various effects but if we consider the initial impact we see that imports are now cheaper for us in the UK. The same 1000 Euros we pay costs us less in pounds and so we have a disinflationary effect on the economy especially for raw materials and oil which go into production.

    On the other side of the coin our exports are more expensive to foreigners as the same £1000 price now costs them more Euros,Dollars or Yen to buy. To the extent that demand for our exports is price elastic demand will fall and so there will be reduced demand for our goods or some deflationary pressure.

    There are caveats to the second paragraph which is that the price elasticity of our exports appears on the 2007/08 depreciation evidence to be a smaller effect that previously thought. Indeed this is now a complex subject. Also the reduction in inflation will over time begin to offset the price change.

    But if we ignore the caveat above we have a downwards impact on the economy and inflation which is what an interest-rate rise would be set out to achieve. Where there is a clear difference is in who is affected as an interest-rate rise mostly affects the domestic economy (a classic example is housing) and the exchange rate the external sector.

    There are contrary effects as to the extent that UK individuals spend abroad they are now wealthier than they were on August 6th.

    But returning to your question this is why I compare the two different factors of a base rate rise and a rise in the £. It is a rule of thumb and by no means perfect but it is better than none at all.

  • Anonymous

    Hi Anteos

    It has a multiplicity of names from citizens income to basic income to perhaps the clearest guaranteed minimum income. It also poses a lot of questions so i will bear it in mind.

  • Anonymous

    Hi Drf

    In general bond yields rose in 2013 with the US and UK leading the pack. The divergence was such that having started 2013 with a lower 10 year yield than France (2% versus 2.08%) we start 2014 with one around half a per cent higher.

    Thanks for the Telegraph link but I am not clear that their excitement over the move in the bund/oats spead is justified much by the facts as it was 0.53% a year ago and is 0.61% tonight. Perhaps they might like to write Gilt/Bund and Gilt/Oats spreads have surged as after all it is true!

    It would be interesting to track down who first coined the phrase Quantitative Easing and ask them why…

  • Anonymous

    Hi Progrock

    Traditionally UK Gilt prices and yield movements are highly correlated with the movements of the US Treasury Bond market. so the answer is yes and in many ways you already have a lot of the explanation for what happened to Gilts in 2013. The missing links are the end of UK QE and the economic improvement.

    Would more QE help in that regard? If you stick to just bond yields only then yes but it is my opinion that the effect has weakened. So a larger amount of purchases are required to reduce yields by say 0.5%. The catch is that on that road they could end up buying the lot which is called endgaming in chess..

  • Anonymous

    Ok, thanks. Surely the effect of QE is weakening not, as economists would normally explain, because it’s weakening in effect like an antibiotic, but simply because more and more buyers are deserting gilts so we have to mop up more and more to suppress the price as the less buyers the lower the price.

    Yes, I agree on the endgame analogy. At this point you have surely just got paper entries and nothing more. It’s not the same as say Japan where individuals and companies are earning then putting their wages back into JPY bonds. With QE we have no middle man.

    On a side note this is interesting:

    http://www.telegraph.co.uk/finance/financialcrisis/10548104/IMF-paper-warns-of-savings-tax-and-mass-write-offs-as-Wests-debt-hits-200-year-high.html

    In a way this sort of item plays into the hands of the state as they are using financial repression to get people out of savings and such news will only see more people go into assets like housing.

    Feels like we are in the eye of the storm now. I’m doubled down on all this. I am on a working visa for a bank overseas with two kids and I have significant savings! I could find myself on a one way ticket back to hell (the UK) with no savings. Squeaky bum time!

  • Eric

    I’ve always thought “Quantitative Easing” was derived from a translation from Japanese. So I guess ‘why’ will be very difficult to answer —- I wonder if “financial tsunami” describes it better?