Carney Talks!

13/06/2014 at 5:07 pm

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.

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