Category Archives: Brexit

GBP isn’t cheap

Over the last few weeks and months I’ve noticed quite a few commentators suggesting that GBP might now be attractive because it is very cheap. For instance “the pound looks increasingly “cheap” in a historical context” (Morgan Stanley March 7). “The pound looks cheap at current levels” (ANZ December 6). “The pound is looking “cheap” from a longer-term point of view” (Scotia Bank March 2). There are plenty of others. The consensus seems to be that the pound is cheap because it is suffering from Brexit woes, and that if those were to fade, or be overtaken by concerns elsewhere in the world, the pound would recover. But I would argue that although the pound is obviously cheaper than it was, it still isn’t really cheap against most of the other major currencies.

If something falls a lot it doesn’t necessarily mean it is now cheap. It’s possible of course. But it is also possible that it is falling in line with long-term equilibrium – i.e. it is no cheaper than it was. Or, more likely, it could be that it has fallen from expensive levels and is now just less expensive, or fair. How to decide? Well, some sort of sensible model of fair value is necessary, otherwise we don’t know where we are starting from, or what affects long term equilibrium.

A lot of people run a mile as soon as they see the word “model”. Models are distrusted. So I’m not going to create anything complicated or use any fancy econometrics. I’m simply going to point out three things.

  1. It is the real value of a currency that matters, not the nominal value. This is just another way of saying that if prices rise in one country or currency area relative to others, then unless the currency falls, things are now more expensive in that country/currency area. In other words, to keep the real value of the currency stable, currencies have to fall if relative inflation is high in their area.
  2. Trade balances and current accounts matter. The bigger your current account deficit the more capital you need to attract to finance it and, other things equal, the lower your currency has to be.
  3. Interest rates make a difference. If you have higher interest rates than others there will be more demand for assets denominated in your currency. This ought to apply to real interest rates (interest rates minus expected inflation) rather than nominal rates, because future inflation would typically lead to currency depreciation (point 1).

I don’t think anyone would argue with these three points. But if these are accepted, I don’t see why people see GBP as cheap.

Point 1 is really the most crucial. While terms of trade and interest rates are clearly important, the impact from changes in export and import prices can take some time to be felt and can be offset by other flows. Similarly, interest rate variations affect short-term demand, but if such variations are cyclical they may not have much impact on long-term value. But where we are starting from in terms of the real value of the currency is critical.

So where does the pound stand in real terms? There is more than one way to measure this, but I will use two main methods. First, let’s looks at the commonly used measure of the real effective exchange rate. The chart below shows the narrow real effective GBP exchange rate, and on the face of it, GBP does look quite weak by historic standards. But looking at it next to the EUR effective exchange rate, it isn’t so clear. Since the financial crisis the EUR has weakened more on a trade weighted basis than GBP. Even more dramatically, the USD is well above the highs seen in the last 20 years

realeffective

Source: BIS

So what’s going on? Well, a little more light is shed if we look at another measure of value – namely GBP versus purchasing power parity (PPP). Below is a chart of EUR/GBP against EUR/GBP PPP.

eurgbp ppp

As this shows, EUR/GBP remains some way below PPP. This is not unusual – it has only briefly traded above PPP in the past. This is itself a little puzzling, and I would argue that it is hard to justify, of which more later. But even taking that as given, EUR/GBP is only marginally stronger relative to PPP than its average in the last 20 years.

So GBP isn’t really weak against the EUR at all. What we are seeing here is not GBP weakness, but USD strength.

This is all the more obvious if you look at GBP/USD relative to PPP, shown below.

gbpusdppp.png

The USD is as strong against the pound (relative to PPP) as it has been since the 80s and the Reagan era. But the USD is strong against (almost) everything. Only the CHF among the majors looks stronger relative to long run fair value.

Now, USD strength is based on the cyclical strength of the US economy, and to that extent is justified in the short to medium term because US interest rates are higher than the UK and Eurozone, and rising. While the UK economy is (arguably) similarly strong to the US, given low levels of UK unemployment, the UK doesn’t have the interest rate advantage. Indeed, real UK rates are the lowest in the G10. Not only that, but the UK also has a massive trade and current account deficit. The chart below illustrates the situation.

yieldcascatter

Source: OECD. Real rates based on 2018 forecasts of PCE deflator

The further north-east you can get in this diagram, the more attractive your currency should be. A big current account surplus, like Switzerland, will normally allow you to have low real rates while high real rates, like New Zealand, will normally allow you to run a big current account deficit. The UK is currently enjoying the worst of both worlds. It’s also noticeable that real rates in the US aren’t all that attractive, and may not be high enough to justify the very high level of the USD. As far as the EUR is concerned, there are clearly other issues at play, including existential concerns. But without even considering the potential future negative impact of Brexit (though of course some of this is included in the real yield), it would make sense for GBP to be well below fair value. The fact that it still trades well above PPP against the EUR, and close to it against the USD, suggests it is far from cheap.

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Policy mistakes should not always be reversed

cpimktfeb17-1

UK inflation is rising

The Bank of England cut rates by 25bp and increased asset purchases in August in anticipation of a loss of confidence after the Brexit vote on June 24. The objective was stated to be to “provide additional support to growth and to achieve a sustainable return of inflation to the target.” Subsequently, growth was substantially stronger than expected through the remainder of 2016, mainly due to strong consumer spending, funded by increased borrowing. Now, many (including myself) thought the cut was a mistake at the time. But we all make mistakes. The Bank’s assessment of the impact on confidence appears to have been incorrect. Of course, some might argue that growth was stronger because the Bank eased policy, and no-one can prove that is wrong, but I think it is far-fetched. The fact is that the majority of the population (or at least half) are in favour of Brexit, so there is no good reason why the vote should have undermined consumer confidence. Business confidence might have been damaged in the longer run, but very few investment decisions are changed in a short time frame, so if there is a negative impact, it is yet to be felt. In practice, the relative resilience of spending may convince businesses to hold their nerve until the new trade arrangements become clearer, which may well take some time, as long as growth doesn’t start to slip back.

So it certainly seems as if the Bank of England made a policy error. While there is still very likely to be a longer term supply side shock from Brexit, that may not happen for quite some time, and the demand side shock the Bank initially expected has not materialised thus far. So what should they do? Should they reverse their easing and admit their error? The latest Inflation Report certainly shows inflation is expected to move above target soon and stay above target for the whole forecast horizon, which would suggest there is a pretty good prima facie case to raise rates or at least halt the increase in asset purchases. But the best way to fix an error is not always to simply reverse policy. Unless the reversal is done very quickly, the environment faced is different from the one faced initially. Things have changed.

In this case, the most notable change has been the decline in the pound. This has been good in some ways, as it has helped sustain manufacturing an export confidence in the face of uncertain future trade relationships, but it will lead to substantially higher inflation going forward, starting quite soon, as higher import prices feed through to CPI. It has also already led to higher inflation expectations. The key question as to whether this is sufficient reason to reverse the policy easing is whether the coming rise in inflation leads to an increase in wages and other factors generating domestically generated inflation. At this stage this is not clear, and is important. If wages don’t respond, we will see a sharp decline in real income growth as inflation rises, and if we also see a rise in rates from the Bank, there is a danger this will lead to a sharp decline in consumer confidence, potentially at the same time as sterling rises in response to a rise in rates. This could make the current optimism about the UK economy evaporate quite quickly.

So at this stage it seems sensible to wait. Inflation is coming, and it would be as well to see how this impacts spending and confidence before acting to reverse the move made in August. There has been a lot of British bravado since the Brexit vote, but high levels of debt and declining real incomes, plus the uncertainty surrounding the trade relationship with the EU and elsewhere, suggest that confidence is likely to be fragile. After making a policy mistake it is important not to compound it. The Bank mustn’t act looking in the rear view mirror.

 

 

A crisis for UK democracy?

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A bit on the markets in a minute, but first a bit of a rant.

If the Daily Mail call High Court judges “enemies of the people” simply for saying that parliament has to sanction the triggering of Article 50, what will it do if some MPs choose to vote against the wishes of their constituents?

This is a difficult issue for some MPs. After all, some are in constituencies that voted to Remain but themselves support Brexit. Others are in Leave constituencies but were in favour of Remaining. The Daily Mail would argue that the people have spoken with the referendum, but the result was close, and had more young people voted might have gone the other way. It might go the other way if it was done again today. So in my view MPs should vote in line with their own views. But they won’t. Even if they are in “Remain” constituencies, and are pro-Remain themselves, very few MPs will vote down a bill to trigger Article 50. Partly because they will be put on the front page of the Daily Mail if they do. And they remember what happened to Jo Cox. This is not a good way to govern a country, and reminiscent of some unpleasant regimes.

Unless MPs are prepared to act as responsible human beings and stand up to their party, the press and the noisy section of their constituents, they are becoming an irrelevance. They are mere ciphers. They are not being allowed to make their own decisions about anything important. It is important to have a role for personal conscience.

The further irony is that Brexit was (according to the Leave camp anyway) supposed to be about taking back control of our government from the EU. But if MPs are effectively just servants of the government, we are effectively being governed by royal prerogative. Come back Oliver Cromwell.

Anyway, rant over. The markets.

Sterling has managed a little rally in response to the High Court decision that parliament has to trigger Article 50, but this doesn’t look like it will be enough to sustain a strong rally in GBP for at least two reasons.

1) Although GBP is now a lot cheaper than it was, it is not dramatically cheap against the USD or the EUR given the big UK current account deficit and the lack of (real) yield attraction available in GBP.

2) Even if the High Court decision is upheld by the Supreme Court, it doesn’t mean no Brexit. Brexit is still extremely likely to happen. There might be some impact on the shape of the Brexit, but even this isn’t clear. If the government sticks to its guns on rejecting free movement and the EU sticks to its guns on making free movement a condition for single market access, it seems doubtful that parliament will really be able to have much real effect. What does seem likely (though not certain) is that there will be a significant delay in triggering Article 50 because of the time it is likely to take to put a bill through the Commons and Lords (average time one year). There could be a simple resolution to speed things along, but this would mean parliament would have to have its say at a later date.

So the vote has created extra uncertainty around Brexit, and has perhaps increased the chances of a softer version and a longer delay. This is mildly supportive for GBP, but some argue that the delay and uncertainty only makes things worse as firms are unable to plan for the future. I’d say this is outweighed by the increased chance of a softer Brexit, but not so much as to justify a dramatic GBP rally. EUR/GBP may manage to get back to the 0.86 area, but unless there is a lot more promise of a soft Brexit or some evidence on Eurozone weakness and/or UK strength gains beyond this are hard to justify. Still, it looks like it might be enough to stabilise GBP in the 0.86-0.91 range.

I have put this in terms of EUR/GBP rather than GBP/USD because coming into the US election the picture for the USD is obviously very uncertain. Most take the view that a Clinton victory will be USD positive, and market behaviour in the run up to the election suggests this is the case, but with a Clinton victory now priced as around an 80% chance, the market reaction may not be huge. The Fed is very likely to hike if markets respond positively – even neutrally – to the election, and that should be enough to sustain the USD against most currencies, though which currencies it gains most against will to some extent depend on the (uncertain) medium term equity market reaction to the combination of a Clinton win and higher US rates.

This is all pretty much the consensus view, and I’m not going to speculate too much on what happens if Trump wins, except to say that I’m not sure the impact will be that sustained. In the end, Washington will put fairly substantial limits on what he is able to do.

EUR weighed down by GBP not Draghi

eurandgbp

Looking at the markets, it seems as if Draghi said that the ECB would be easing further come December, or at the very least March. The EUR has gone into a tailspin since the ECB meeting, and journalists are queuing up to blame Draghi. The trouble is, no-one seems quite sure what he said that triggered the move. One headline said “Euro close to 8-month lows vs dollar Friday after ECB chief Mario Draghi ruled out an abrupt end to QE.” Another headline “Euro wallows near March lows after Draghi quashes tapering talk”. So did he quash taper talk, or did he say the ECB would taper? Because if you don’t end abruptly, you taper (it’s one or the other). And which is better for the EUR? Because when it was suggested that the ECB would taper a month or so ago (by some unnamed committee member that Draghi emphasised had no insight) the EUR went up. So presumably if they don’t taper it goes down? Except Draghi said they would taper. Which I would have thought was sensible, and less likely to be EUR positive than an abrupt end to QE if anyone thought about it. Which all probably goes to show how silly the original “taper tantrum” was, but doesn’t really explain why the EUR has been so weak since Draghi’s press conference, especially since the effects of the initial taper tantrum were fairly short-lived in any case because on reflection most saw that the initial story didn’t mean a great deal, true or not.

In reality I don’t think the market really saw anything new in Draghi’s comments, but in the absence of anything new, the downtrend in EUR/USD remains in place. EUR/USD has been in a downtrend since the Brexit vote, and with the market expecting a Fed rate hike in December and currently seeing a probable Clinton victory as favourable (presumably because it is essentially the status quo – no nasty surprises), the burden of proof is now on those that want to oppose the EUR/USD downtrend. It is interesting that the Brexit situation appears to be the key factor that has pushed EUR/USD lower, though the UK is a small economy by comparison to the US and Eurozone giants. It is certainly the case that EUR/USD has never regained the 1.1377 high seen on June 24 and had been edging higher into the vote. It is hard to see that the economic news form the two economies since then has been particularly USD positive or EUR negative. If anything the opposite is true. Certainly since the beginning of this year the performance of the Eurozone in both growth and inflation has been broadly in line with expectations, while US growth has significantly underperformed. In fact, the OECD currently expect US GDP growth to be weaker than the Eurozone’s this year, and although many expect the Fed to raise rates in December, this is significantly less tightening than had been anticipated  at the start of the year.

So we need some change in market perceptions for the EUR to stop falling, at least until we reach the key levels in the 1.05-1.08 area in EUR/USD. A less negative view of Brexit from the perspective of both the UK and the Eurozone is the most obvious potential trigger, though that doesn’t seem imminent with the EU ruling out negotiation until the UK invokes Article 50, which most likely will be in Q1 2017. The other main possibility is a change in the perception of the Fed, though the way things have turned out this year suggests that even if the Fed don’t raise rates in December, the hit to USD strength may only be temporary unless the ECB turn out to be unexpectedly hawkish at their December meeting. The third chance of a Trump victory is one I hope we don’t have to consider.

GBP weakness overdone?

Well, yes and no. I think the lows seen overnight represent a reasonable idea of the base for GBP, but we may well have another look at them before we go higher. I would argue that while the bad news about Brexit is now broadly in the market, there are few reasons to buy GBP, and levels are still not that attractive, so I would still prefer the downside for now.

The overnight moves were clearly exacerbated by poor liquidity in Asian hours, though it’s still surprising to me that liquidity is that poor. It seems that in the new algo dominated world such moves are becoming more frequent, though it is more surprising in GBP than it was in the CHF when there was a clear change in regime in the removal of a floor. Exotic options structures may have been responsible, but I am not totally convinced by the explanations I have heard.

Anyway, GBP has bounced back after the sharp dip overnight, but buyers will now be even more wary than they were and the prospects of recovery consequently that much less. Was the weakness overnight justified by events? No, in that nothing changed dramatically enough to trigger such a sharp fall. Underlying concern about a “hard” Brexit is behind the negative GBP sentiment, but does this mean GBP is weak indefinitely until the reality of the trade arrangements are realised? Surely not, as we may see no clarity for years. What we are seeing from May, Hollande, Juncker, Merkel et al. isn’t even negotiation yet. The UK hasn’t even triggered Article 50. This is just the pre-negotiation posturing – the trash talk before the big fight. I don’t know what the trade relations between the UK and the EU will look like in the end, but I suspect there won’t be the radical step change in trade that some seem to think. The bad news of a “hard” Brexit is now essentially in the market, so may be there is no more to come and GBP has hit its lows. This is certainly possible, but the problem is that the pound still isn’t particularly cheap.

There is more than one way of assessing value in FX, but I will show three charts here to illustrate why I think GBP is far from being significantly cheap. It is broadly fair against the USD, but it is still expensive against the EUR. I have published these before back in June before the Brexit vote as reasons why, even if there had been a vote to Remain, GBP was too high.

The first chart underlines that GBP is still well above PPP against the EUR. While currencies don’t necessarily trade near PPP, it is a good starting point, and it can be seen from the chart that GBP has generally traded a lot closer to PPP against the EUR than it did in recent years. There was some justification for higher GBP valuation at the height of the EUR crisis, including higher UK yields and greater perceived security, but the yield advantage has effectively vanished and GBP now also looks more risky and less secure, so the justification for trading above PPP is much reduced.

Against the USD the tendency until the mid noughties was to trade close to PPP. Subsequent GBP strength may have been a result of reserve diversification by major central banks (among other things) but current PPP is around 1.32, so we are only marginally below there.

The third chart illustrates how major currency levels versus PPP generally correlate to the size of the current account deficit/surplus in each currency. On this basis GBP looks about fair, while the EUR looks very obviously cheap and the CHF exceptionally expensive. The relatively high valuation of the NZD and AUD reflect their higher yields. The cheapness of the EUR and the high level of the CHF suggests the CHF is the proxy DEM, but sooner or later I expect this will also be corrected.

eurgbppppoctober16

Source: OECD, FX Economics

gbpusdpppoctober16

Source: OECD, FX Economics

fxvalueoctober16

Source: OECD, FX Economics

 

 

 

 

Carney, Prince of pessimism

hamlet

“There is nothing either good or bad, but thinking makes it so”. Hamlet

The most striking thing to me about yesterday’s raft of information and decisions from the Bank of England was the willingness to act on the basis of forecasts of significant near term economic weakness based on, let’s face it, remarkably little solid evidence. This has continued the trend of the Bank supporting the view that the Brexit vote is a disaster and will lead to a major economic slowdown, a view that is becoming self-perpetuating.

Now, of course, the Bank of England has to try to act on the basis of forecasts, and if it merely responds to coincident or lagging indicators of the economy it risks being seen to be “behind the curve” or setting policy “looking in the rear view mirror”. But we are in a unique situation here. No-one has ever left the EU before. We don’t know what the UK trade arrangements will be in the future, and these will in any case not be in place for more than another two years. The Bank takes the view that the ultimate result will be some reduction in UK supply capacity in 2019 and beyond, though it admits the extent of this effect is very uncertain. Fair enough. But the measures announced yesterday were not really intended to deal with this, but with the short-term demand reaction. It is here that I think the Bank is on very shaky ground, for several reasons.

First of all, we should need no reminding that the Bank’s record of forecasting under Carney has been woeful, from the initial unexpectedly sharp decline in unemployment which quickly left his conditions for raising rates looking ridiculous, to the more recent indications that rates were likely to go up rather than down. Carney’s reputation as an “unreliable boyfriend” is therefore to some extent justified, though I would argue his fault is not so much a lack of foresight – as all forecasters know, being wrong is the norm – as suggesting he has more confidence in his foresight and consequently his understanding of the correct policy path than he had any real right to. Of course, there are uncertainty bands around all the Bank of England Inflation report forecasts, but Carney has always tried to provide an impression of greater commitment to a view than these suggest, in contrast to his predecessor Lord King, who increasingly emphasised that neither he nor anyone else knew the answers to many of the questions he was asked.

So it would be foolish to take the Bank’s forecasts as gospel, even in normal times, and one of the main points made by the Bank yesterday was that these were more uncertain times than usual and that there had been “sharp rises in indicators of uncertainty in recent months”. Once again, fair enough, But the Bank goes on to conclude that such uncertainty could lead to a reduction in spending, particularly major spending commitments. Well, maybe, but maybe not. The impact of uncertainty is very – er – uncertain. Uncertainty squared, if you like.

Of course, as former MPC member Charles Goodhart has noted, we always think the situation is uncertain, and this is not an excuse for doing nothing. That only leads to vacillation. The Bank has taken a view that further monetary accommodation is needed because the risks are on the downside. Again, as Goodhart has pointed out, the impact of these measures is unlikely to be very large, as monetary policy has close to run out of bullets, but they are unlikely to do any harm, at least directly.

So my problem is not with the measures per se, or even the broad slant of the analysis, but with the presentation.  The Bank accepts that there is a lot of uncertainty, and worries that this will lead to less spending. But the reaction of people and businesses is not set in stone. It is about confidence and sentiment. The Bank’s policy reaction is not so much about the actual shape of the trade relations in years to come, but the reaction of firms and consumers to worrying about it. The best way of dealing with this is not to say – “yes, things are pretty awful, so here are some measures that might be a bit of a help if things turn out to be as bad as we fear”. It is to take as positive approach as possible, say that we don’t really know what is going to happen down the road, but there is no real need to change our behaviour now as the picture in two or three years time is really entirely unknown. Brexit may not even be the most important thing that happens over that period. For instance, if the Eurozone’s nascent recovery continues, helped by some expansionary fiscal policy, it may swamp any negative Brexit impact (if there is any).

Now, there is of course some need for transparency, and Carney has taken the view that it was the responsibility of the Bank to put out its best guess of the impact of Brexit ahead of the vote. But I feel this was the first error that has been compounded by subsequent acts. You don’t have to believe, like some on the Treasury Select Committee, that there was a sinister political motive behind the Bank’s negative forecasts ahead of the vote, to think that a more humble view would have been far less damaging. If the Bank had merely said that the impact was uncertain and it would react when there was some greater clarity, the idea that a big slowdown was inevitable would not have become so ingrained, and firms and consumers would be less inclined to believe they should put off big spending projects. The latest Bank action might still have been the same, but could have been presented as an insurance policy rather than a reaction to an inevitable sharp downturn. Now we are in danger of talking ourselves into a downturn, and producing a fiscal expansion we can ill afford to offset it.

Perhaps Carney should have spent more time reading Shakespeare rather than learning about DSGE models. Then he would know that “there is nothing good or bad but thinking makes it so”.

Short term risk recovery

blues

“It’s dark, and we’re wearing sunglasses”. The Blues Brothers

So we’re in a bit of limbo Brexit-wise. We don’t know when it will happen (some say even if it will happen), what trade deals will be done, who will be allowed to stay in the UK when we leave, how the elections elsewhere will go, and so on. Still, it is reasonable to say it will have some negative impact on the economy on the short-term. Increased uncertainty will reduce investment by at least a few firms, though it may only be delayed if we finish up with a comparatively benign outcome. I am less sure there will be any direct impact on consumer spending, but the decline in GBP will raise prices and reduce real incomes and spending as a result. Conversely, the impact of a weaker pound on exports may be positive eventually, but not in the short run and perhaps never. While UK exports will be cheaper, it takes time for new orders to be found, and the pound still isn’t cheap enough for the UK to compete in most areas. Plus exports to the EU may suffer because of the lack of any detail on the future relationship. All this is broadly known and in the price, but the extent of the economic impact is very uncertain.

We won’t get any post referendum data until August, and it may be that it is hard to see a clear impact for a few months even if there is a slowdown. So we’re driving if not blind, then at least in the dark with sunglasses on (like the Blues Brothers).

The Bank of England needs to decide this week whether these conditions justify some new action. They have already eased capital requirements on the banks but many think this is just a preamble to a rate cut, as bank profitability will now be partially protected. Carney has said he believes some monetary easing is justified. Many think a rate cut will be delayed until August, but we will know very little more in August than we do now. So I expect the Bank will cut rates this week, though other measures are also possible. It probably doesn’t matter too much exactly what the measures are, as in reality the issue is building confidence rather than adjusting the cost of borrowing.

What will be the impact on the FX markets? If there is no action risk will suffer and with it the pound as well as the other “risky” currencies. If there is a cut an initial dip in the pound may well prove a buying opportunity as risk recovers. The Bank knows that something is expected and is unlikely to take the risk of doing nothing because of the probable negative impact on markets of what would be perceived as dithering. Carney has effectively forced the hand of the rest of the Monetary Policy Committee by saying action is necessary. So look for a bold Bank and a risk positive reaction, especially since the global background is better after the better US employment numbers and the withdrawal of the ludicrous Leadsom as candidate for PM. EUR/JPY (or probably better still, SEK/JPY) seem the cheapest major currency pairs to me. Of course, it may not last if the economic impact of the Brexit vote turns out to be very negative, or if the negotiations between the UK and Juncker and co. break up in acrimony. But for now, while the outcomes are unclear, expect a risk recovery as the Bank tries to build confidence.