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.
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.
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….