BOE worried by weakening UK economy, but leaves interest rates on hold

6th September 2012

It said that this was likely to lead to more quantitative easing (QE). This, of course, was welcomed by markets, but has the Bank of England now created a situation where – for many market participants – the risks of economic recovery are greater than the risks of continuing weakness?

Fears that the US government may not announce another round of quantitative easing have pushed gilt yields below those of US treasuries for the first time. It is a sign of the extent to which the assumption of QE is driving down bond yields and therefore the potential impact of a normalisation of monetary policy. There are an increasing number of market participants for whom the resumption of economic growth could be a significant problem.

According to estimates from Schroders, banks, institutional investors and other private investors will have to plough an extra $1.4 trillion into US Treasury bonds over the next five years, an increase of more than 50% on the past period. This creates a lot of market participants who would suffer if yields were to rise.

Schroders chief economist Keith Wade believes that people will continue to buy in spite of the risk of capital loss: "De-leveraging, demographics and a shortage of safe assets are already pushing institutions in this direction." However, he also believes that the scale of investment is likely to make investors baulk, resulting in upward pressure on bond yields over the medium term. 

As the Bank of England pointed out, economic recovery still looks some way off. The reason for the lower yield on UK gilts is perversely, a reflection of the UK's relative weakness rather than its relative strength. The US may not be in perfect economic shape, but markets are starting to believe that it is not sufficiently bad to warrant additional quantitative easing. The UK, on the other hand, looks set to continue quantitative easing, which is depressing yields.

 "A recent uptick in US economic data, particularly in the housing and labour markets, has compelled some investors to pare expectations that the US Federal Reserve will unveil a third round of quantitative easing, or QE3, next month.

"In contrast, the UK's economic output has contracted for three quarters in a row, spurring the Bank of England to announce earlier this summer another £50bn of quantitative easing through to November."

However, markets will begin to anticipate economic recovery some way ahead of an actual recovery. The holders of an asset paying 1.45% (the current yield on the 10 year gilt) will suffer in a climate where interest rates are – or are expected to be – 3-4%. The worst case scenario for gilt holders would be if inflation took off at the same time. As such, economic recovery and the resulting normalisation of interest rates holds greater risks for certain members of the UK population than ongoing economic weakness.

At a basic level, the largest holders of gilts will suffer most. As the latest statistics show, around a fifth of the gilt market is held by the Bank of England. Overseas holders make up around a third of the market, while pension funds and other institutional investors form another significant chunk. The low borrowing costs also flatter the government's debt repayment statistics, though this would, to some extent, be counter-balanced by the improvement in economic performance.  

Wade suggests that a rise in yields may not necessarily be bad news. He says: "Rising yields and the return of the bond market vigilantes may ease policy gridlock and focus the minds of politicians on reducing the budget deficit." 

However, there remain real risks of capital loss for those who have soaked up all of this issuance. These market participants are better off with a continuation of the current climate rather than a resumption of growth and therefore normal economic policy. The question is the extent to which these participants will sway policymakers, who may be forced to continue the status quo for longer than the prevailing economic climate may require. This would be the climate for another boom, but surely people's memories are not that short?


More on Mindful Money:

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12 thoughts on “BOE worried by weakening UK economy, but leaves interest rates on hold”

  1. Mike from Enfield says:

    Thanks Shaun for a most informative article.

    The obvious question is, why not simply switch from gross to value-added data. Are the figures harder to collate, historical vestiges or just less convenient for the politicians?

    1. Anonymous says:

      Hi Mike

      I think that two of your suggestions certainly apply which is that they are harder to collect and are less convenient. However one of the UK’s MEPs has contacted me to say that after reading my work on this she asked Eurostat about it and here is there reply.

      “I did ask Walter Radermacher of Eurostat if they were looking at value added, I think the reply effectively ‘trying to’.”

      Make of that what you will…..

  2. Justathought says:

    Hi Shaun,

    Thanks for the explanation,

    It appears that many things do not add up, not only on the
    economic measurement but in most area of life…wrong perceptions, wrong beliefs… this “human” world seems utterly insane! Sure your Martian’s friend will be completely confused? He will run as fast as he can to the other side of the galaxy…definitively to keep his sanity! In the meantime let’s enjoy the circus…

    1. Anonymous says:

      Hi Justathought

      In economometrics very little adds up and when it does it is mostly misleading!

  3. Anonymous says:

    Shaun, Very interesting! I believe that the Euro poster boy, Ireland, suffers from this to quite a large degree although a lot of their numbers are simply sales and profits booked via Irish companies. It would be interesting to have an accurate analysis of the Irish situation as the reality ‘on the ground’ has no relation to the economic headlines.

    1. Anonymous says:

      Hi Pavlaki

      Good point I should have put Ireland’s numbers in so let me put that right. Some 42% of Ireland’s gross exports in 2009 vanish if you use the value added methodology. To put it another way they shrink from 86.4 billion Euros to circa 50 billion. Quite a difference isn’t it?

  4. Mike from Enfield says:

    In a similar vein, the BBC reports that UK manufacturing is picking up. I hope it is true.

    As usual the figures are reported without context but backed up by ‘experts’ from the banking sector. It seems that the influence these experts have within their own organizations is distinctly limited however, as lending by banks has gone down even further.

  5. Rods says:

    Hi Shaun,

    A very interesting article. I agree it is good that the OECD has produced these figures.

    I would think the value added figures are much more difficult to produce as it would require much more data from businesses in the way of origin and price of raw materials and subassemblies.

    China is interesting as the growth figures from all of their provinces appear to be higher than the compiled figures from the government! There also seems to be some discrepancies in falling power consumption figures and the rate of reported growth, unless their industries really are getting that much more power efficient?

    1. Anonymous says:

      Hi Rods

      I have covered discrepancies in Sino-US trade data before as what one supposedly exports to the other is not what they claim they import!

      Here is the OECD analysis of how China’s position changes using the value added methodology.

      “The domestic value added embodied in exports and intermediate imports embodied in exports combine to reveal notable differences in China’s trade balance positions with some of its major trading partners (as recorded in the OECD-WTO TiVA database). Typically the pattern is characterised by smaller deficits with
      Factory Asia and smaller surpluses with Europe and North America, with the trade surplus with the United States shrinking by one-third when measured in value added terms”

  6. Noo 2 Economics says:

    Hi Shaun,

    “One more time we find that we know less than we thought we did”. How right you are as I’m confussed. Please can you explain to me the difference between “gross trade” and “value added trade”?

    As I understand it “Value added” is that value added to a product/service at each identifiable stage of production as the next business develops/improves it a bit more. If this is right fine, if not please define it to me and then explain what “gross trade/exports” is because at the moment I cannot understand this argument. Thanks.

    1. Anonymous says:

      Hi Noo 2 Economics

      Let us say that a Jaguar car is shipped to the Netherlands because a company there has unique skills in rust proofing. In value added terms then the only entry will be the value of the rust proofing and some transport costs.

      However in gross terms

      Imports: One Jaguar

      Exports: One rust-proofed Jaguar (and perhaps some transport costs).

      1. Noo 2 Economics says:

        Thanks Shaun, understand it now.

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