Archive for June, 2014

The European Question

Europe has been much in the news again lately. David Cameron expressed a preference for the Presidency of the European Commission to go to an unknown arch-federalist other than the one seemingly favoured by his fellow leaders. This is exciting enough. But a wiretapping scandal in Poland, which initially passed unnoticed when as a purely local matter it threatened only to unseat the governor of the Polish central bank and plunge the ruling party there into crisis, is more exciting still. According a magazine report, foreign minister Radosław Sikorski – who to top things off was once a member of the Bullingdon Club – has, in the even-handed vocabulary of the BBC, “criticised UK Prime Minister David Cameron’s handling of EU affairs”:

He goes on to say, using expletive-laden terms, that Mr Cameron messed up the 2011 EU fiscal compact on budget discipline, which the UK tried to block. “Because he’s not interested, because he doesn’t get it, because he believes in this stupid propaganda, he stupidly tries to manipulate the system,” Mr Sikorski was quoted as saying.

Readers might well have forgotten that the fiscal compact of which Mr Sikorski speaks began life as a putative new EU treaty, which Britain vetoed in December 2011. It subsequently took off as a “compact” between every EU member state except the UK and the Czech Republic – though the Czechs are due to sign up any minute now if their new leader has his way. Once again, Britain looks destined to stand alone, etc.

Whether or not we forget about it, however, Europe marches on. While it has not received any attention, the fiscal compact has been making and is set to make further advances. The budget rules and submission timeline agreed back in 2011/12 have already swung into action: last October saw the first occasion on which every nation signatory to the compact had to present its annual budget to the Commission for scrutiny. And from 1 November this year, prudential supervision of financial institutions in all signatory countries – not just eurozone members – will become the prerogative of the ECB.

It is traditional to interpret the plenipotence of Brussels from a position of coyness. For example, the fiscal compact sets the Commission up with the same sort of mandate as the OBR here in Britain: a dispassionate and final compiler of economic data for national budgets. Yet EU member states still possess every freedom to come up with their own data (in some areas, for now). This is why Spain was able to dismiss the EU’s concerns over its budget this year as “a mere difference in growth forecasts”, and proudly plead that deficit targets would, nonetheless, be met. For Italy, facing similar concerns, the answer was even simpler. By the time this year’s budget had received Commission feedback the country had already decided – quite independently – to privatise a few more state assets, thereby meeting its solvency targets while not bowing to usurpation of fiscal policy at all.

It is at times like these that one can become grateful for England’s generous allocation under the Common Humour Policy. But for those taking a medium term view of European affairs and Britain’s continued involvement with them there are three very serious points to take on board.

  1. The sovereign debt crisis for Europe in particular was / is a defining moment in its history: the goal of “ever closer union” became not just a political ideal but an imperative of economic survival.
  2. The United Kingdom benefited throughout the crisis – however irrationally – from having decided to remain outside the euro.
  3. The UK view on the necessity of “ever closer union” has thus diverged ever more markedly from the views of other EU states, and those of the euro countries especially.

So what comes next?

Most obviously, point (3) will persist. ECB supervision of Britain’s banking system is not seen as necessary, will not happen this November – uniquely, perhaps, in the EU – nor will it happen in the foreseeable future. British budgets will not be subject to Commission scrutiny. Indeed, compliance with the fiscal compact rules in that regard would require us to change our tax year to match the calendar year, as it does elsewhere: the financial equivalent of metrication and likely to be just as welcome.

More broadly, Britain’s position in the EU has never been quite as comfortable as it has been for other, equally proud sovereign nations such as Luxembourg. That level of comfort seems ever more unlikely to improve. This blog quoted one expert observer on the subject back in November 2011, after that month’s emergency summit but before the UK veto had been exercised:

A rival treaty organisation, predicated on common economic government, would become de facto the new forum for integration. One by one, political powers would pass from the EU to the eurozone until the EU became a shell, an amplified free trade area, a kind of EFTA-plus. Which, of course, would suit Britain very well indeed

Two and a half years ago, a two-speed EU looked like a dramatic idea. Today it is getting closer to being policy, on all sides. In another two and a half years’ time the UK could be on the brink of a decision as to whether or not to remain a member of the EU at all.

When it comes to the gathering European question of Brexit we should apply the same quality of analysis as we do to markets. Forget about the fluff – who said what on which tape, which faceless figurehead gets to be Chief Bureaucrat for the next six months, or what precise party postures are adopted to squeeze votes out of people that electoral cycle. The years we have just lived through represent exactly the sort of tectonic movement that causes major earthquakes. Whether we like it, or want to believe it, or not: these years have widened the English Channel, and undercurrents which were always there have grown more powerful.

It’s possible, if not a little hopeful, to see how Britain’s increasingly likely exit from the EU as the relationship now stands might benefit all involved. Of course it might also be a disaster. As a pair of alternatives that at least speaks to volatility. And over the medium term, we should be prepared.

27/06/2014 at 6:37 pm

Carney Talks!

June 2014 is turning into The Month of the Central Banker. Last week it was the rock star, Mr Draghi, on stage; this week it has been our own (imported) Mr Carney. Yesterday the Governor of the Bank of England set pulses racing when he announced that the base rate, pegged at 0.5% since March 2009, could be heading higher “sooner than markets currently expect.” Never mind that the pace of rises would be “gradual and limited” – nor that there was much else of interest in yesterday’s news about Bank control of mortgage lending criteria, multi-currency facilities and broker lending too. Rates are going up! was the cry that markets took.

The pound, while off its highs for the day, strengthened materially, especially against the euro. The FTSE 100 is back down where it ended April. Short dated gilts took a hit. And market expectations for the base rate, as measured by the three-month LIBOR future, have moved higher in large volume (£234bn worth of the December 2014 contract alone at time of writing).

Yet the moves do not reflect anything like a proper panic so we should not blame Mark Carney for putting on a lousy act. And after all, he has the fundmentals behind him. The UK economy has been growing  strongly – why, we are on track this very quarter to produce the same level of output, in real terms, as we did at our peak over six years ago! And unemployment figures out on Wednesday showed the ILO survey measure down another 0.2% to 6.6%, now lower than in Germany. Pretty soon, even the Bank of England’s pie-in-the-sky inflation modelling will begin to suggest a rate hike is warranted.

There is a more interesting debate to be had, and it is this: how might we expect markets to behave once rate rises become a reality?

With equities down, bonds down, the currency stronger and the property market apparently in the Old Lady’s sights the answer may seem obvious. In any case, with those LIBOR markets now expecting the first rise to come as early as September, it is not that academic.

Doom among asset classes is but rarely universal, however. The market is now pricing for 1-1.25% of tightening in the year to September 2015. This is consistent with the 1.25% occurring from June 2006 to July 2007 and the 1% from October 2003 to August 2004. Taking a proper recession as a starting point, the pace of hikes from July 1994 to February 1995 was a little more aggressive (1.5% over that much shorter period), but policy history and inflation expectations were also different back then.

The gilt market knows all this. But it has had a good year, and might just be expecting inflation over the longer term to remain as subdued as it has been in recent months. In an environment where global activity is picking up, and the Bank of England is sufficiently worried about prices to be hiking base rate for the first time since 2007, there is surely a risk that longer-dated interest rates will have to rise alongside shorter ones.

At the same time, equity markets have generally risen as interest rates have gone up, not fallen, reflecting an alignment of future views on economic, price and earnings growth. Dislocations such as an inflation crisis or the ERM debacle and other factors can skew this logic, but the fact is that over the last 20 calendar years, the base rate has risen across seven of them, and the FTSE 100 index then fallen only twice. When rates have fallen, over eight of those years (they were flat the rest of the time), equities have also fallen twice. We should at least read into this behaviour that the direction of short term interest rates is a poor predictor of equity market performance and not, perhaps, be too concerned about today’s falls as a result.

The message is similar for the currency. The fate of the pound will also hang on what everyone else’s interest rates, growth patterns, equity markets and so on are doing: “rates up, pound up” on anything other than a highly temporary basis is not a view ever worth taking. (Over the longer term, purchasing power might be able to tell us something about the likelihood of sterling’s regaining its pre-Great Recession highs, but that is another story.)

An interesting week for observers of the UK, then, but not one which has provided much of predictive use from short term reactions. Taking a step back, we should view Mr Carney’s announcement as perfectly consistent with a strengthening economic recovery in Britain and around the world – if, of course, that is what we continue to get. There are ideas that might well give us about investment decision making, and it is in the context of such ideas which this week’s news from the Bank should be considered.

13/06/2014 at 5:07 pm

Rock Star Central Banker

That is how one London-based analyst described Mario Draghi, ECB President, in an interview with Bloomberg this morning. Markets had been waiting to see what the ECB would do about the threat of deflation and this week their patience was rewarded: Mr Draghi announced an eye-catching €400bn package to stimulate bank lending and a headline-grabbing negative interest rate.

His announcement had some remarkable results. Peripheral bond yields in Europe fell still further: the ten-year Greek bond yields comfortably less than 6% again, the spread between Italian and German government bonds fell to another three-year low, and at the time of writing the yield on Spain’s ten-year benchmark remains below that of the ten-year gilt. The so-called “crossover index” of low-grade European credit spreads reached another pre-crunch low, and is within sight of where it closed 2006. The eurozone blue-chip Stoxx 50 index reached new highs. After an initial dip down the euro closed up more than half a cent against the dollar.

If Mr Draghi is a rock star, then, the crowd love him. But how radical are the changes he has actually put forward?

Having a negative deposit rate seems like a significant move. But the reduction is all of 10bp, from 0.0% to -0.1%. The impact on bank margins is therefore of mostly presentational significance. Nor are negative rates – even in Europe – as much of an innovation as all that: Sweden ran a deposit rate of -0.25% for a year from mid-2009, and the Danish Central Bank’s offered rate on certificates of deposit was set at -0.2% in mid-2012, only turning positive again this April. Longer rates have been negative too, with one-year German government paper dropping below a zero yield several times as fears over the sovereign debt crisis persisted over 2012. Consider the level of rates in real terms, of course, and this becomes even plainer, with reference interest rates well below inflation over much of the developed world now, including Japan.

The €400bn bank liquidity programme, in practice, is even less dramatic. It is limited to 7% of the value of lending to non-financial corporates and household borrowers by bank, will not kick in until September and then will only be phased in on a quarterly basis. Another programme, designed to cover net corporate lending with centrally-borrowed cash, is not scheduled to start until next March; and in terms of outright quantitative easing, all the ECB said is that it will “intensify preparatory work related to outright purchases of asset-backed securities”, which hardly sounds exciting.

The real benefit of this week’s announcement, therefore, has been the market reaction. The same goes for the ECB’s last big programme announcement back in September 2012: outright monetary operations, enabling the bank to purchase an unlimited quantity of short-dated government bonds in the event of emergency, billed in advance over the summer as doing “whatever it takes” to save the euro. It drove markets wild with relief. The number of times it has actually been used since? Precisely none: the market response was outcome enough.

This is not to dismiss the importance of “open mouth operations”. While its policy response to the credit crunch itself was exemplary, for instance, the Federal Reserve caused major carnage on two occasions further down the line: its botched announcement of “Operation Twist” in the autumn of 2011 undermined a sensible policy by heaping further panic on already fearful markets, and the announcement of QE “tapering” a year ago caused some of the most significant market dislocations in recent history. Having seen what can happen when central bankers get their delivery wrong we should be pleased that Mr Draghi, so far, has been getting his right.

There is a fundamental point worth raising too. Further emergency action from the ECB – received wisdom aside – is not necessary.

Lots of people “know”, for instance, that deflation caused a lost decade in Japan. These people agonize that the same may happen on the Continent. But what about deflation in … Switzerland? CPI inflation was at or below zero there for two years from October 2011, fell to a low before that of -1.2% in mid-2009 and has averaged -0.1% and +0.6% over the last five and ten years respectively. Yet the Swiss economy experienced one of the shortest and shallowest downturns of the Great Recession, and unlike the eurozone did not experience a double dip. It might just be, therefore, that deflation is at least as much a symptom as a cause of economic malaise.

On a similar note, there is a widespread assumption that the ECB needs a weaker euro. But is this true? If low inflation is a symptom of high unemployment and slack growth, what more would a weak currency deliver when the current account surplus has already been reaching record highs? On the other side of the coin, over the year to May – when eurozone CPI inflation fell to 0.5% on the year – the euro had only strengthened by 1.3%. Most of the currency’s appreciation came much earlier: from May 2012 to May 2013, for example, it was up over 8% on a trade-weighted basis. And in May last year CPI inflation was running at 1.4%. This should make it rather difficult to believe that Europe has been importing deflation.

We shouldn’t get carried away with the eurozone’s economic situation to anything like the point of jealousy. Remember disappointing growth and regional disparity. And it would be great to see some credit growth there along with other recent signs of recovery, such as the peak in unemployment and the strongest retail sales growth in more than seven years.

However, a proper analysis suggests that Mr Draghi has indeed been playing to the crowd as much as anything this week. Why not, when this can be as important to a central banker as a rock star?

The next time he puts on a big performance, let’s hope that too is a hit.

06/06/2014 at 3:37 pm


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