Category Archives: GBP

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.

 

 

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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”.

The value is in EUR

The short term focus in FX has been on central banks. The lack of BoJ action,  diminishing expectations of action from the Fed, and the ECB approaching the limits of easing have all contributed to a strong JPY and EUR and weaker USD, while today saw the RBA sucked into the anti-deflation battle once again, halting the AUD recovery. The rationale for focusing so much on minor changes in central bank policy seems to me to be very flawed, and the scale of the reactions on the face of it looks excessive. But what appears to be excessive volatility in reaction to minor news may in fact be something else. It may be a reflection of very out of line initial valuations. As the market’s love of the USD and the story of widening yield spreads fades, recent sharp moves may reflect a realisation that valuations may be a long way out of line if the focus is changing. This is important for anyone looking beyond the short term, and even short term traders should be aware that with the long term USD uptrend under threat, the dominant paradigm may be shifting.

The simplest way of looking at value in FX is to consider real trade-weighted indices. These provide a comparison of the real value of currencies over time. I have put together a chart using BIS data rebased to February 1987 – the data of the Louvre accord when the major countries tried to stabilise currencies. This is not necessarily representative of fair value for reasons I will elaborate on later, but is a reasonable place to start. On this basis, the JPY looks the cheapest of the major currencies, and the Swiss franc the most expensive. The USD went from cheap in 2013 to expensive by the end of 2014 and extended its valuation though 2015. GBP also looks expensive on this basis, albeit a little less so than it was, while the EUR is on the cheap side.

realeffectives

But valuation on this basis misses out two key factors. First, the possibility of structural change and second the cyclical movements in currencies that result from movements in yield spreads. Of course, the latter is by its nature a temporary phenomenon, and cyclical movements in currencies always looks excessively volatile based on yield spreads. The increased attraction of higher yields makes a currency more attractive, but currency moves typically substantially overcompensate for the increased expected return. This is why a change in market sentiment can conversely produce an apparently excessive reaction in the opposite direction, as in the recent move in the JPY.

However, structural changes can and should have a sustained impact on currency valuations. I tend to look at this in terms of movements in the current account. Currencies with big current account surpluses tend to be more highly valued than those with a deficit, as a current account surplus represents a persistent flow into the currency which needs to be offset by capital flows in the opposite direction, encouraged by a higher currency. Changes in the terms of trade are one major factor that can change the structural current account position, but other factors can also have an impact.

In the current situation, the most notable current account changes in recent years have been the rise in the Eurozone current account surplus, the rise in the UK deficit, and the decline, and more recently recovery, in the Japanese surplus. These are important changes, because the history of the real exchange rate index has to be coloured by such structural changes. So the weakness in the JPY we have seen until recently was in part justified by the deterioration in the Japanese current account position. However, the recent improvement suggests some scope for the JPY to recover, especially since the weakness had in any case overshot somewhat. Meanwhile, the big rise in the Eurozone current account surplus justifies a stronger EUR valuation, and the converse is true for the UK.

Now, movements in the current account are also cyclical, with stronger growth economies typically having bigger deficits, and cyclically improving current account positions are not normally positive for a currency, because they are usually accompanied by independent capital outflows towards higher growth economies, usually because of higher or rising yields. But when the relative growth underperformance stops, the surplus doesn’t quickly disappear, and the surplus may become the dominant factor. This is the situation now in the Eurozone. The EUR not only looks cheap on valuation, it is even cheaper when the recent current account improvement is taken into account, and currently the Eurozone is also actually growing faster than the US or the UK (at least in Q1 2016). So something of a perfect storm for the EUR.

As for the JPY, while it looks the cheapest currency compared to history, it is probably less cheap than the EUR when the recent structural changes are taken into account. This is illustrated in the chart below.

 

valuemodel

So in the longer term I would see plenty of further upside for the EUR. However, in the short to medium term, the USD and GBP could recover if relatively strong US and UK growth returns and yield spreads resume the widening trend. Nevertheless, while his could happen in the next few quarters, I see little scope for this to continue longer term as cyclically adjusted budget positions in the US, and particularly the UK, need to be reined in. In comparison, the Eurozone has potential to expand budgets being that much further below trend output and full employment.

 

GBP – History repeating.

It’s all just a little bit of history repeating” The Propellerheads

“We learn from history that we do not learn from history.” Hegel

“The history book on the shelf is always repeating itself” ABBA

Instinctively, I tend to assume the human race has made progress over the last 100 years and our understanding of most things has increased dramatically. Technology has advanced enormously and clearly one thing that has changed in financial markets is the ability to access liquidity in all manner of financial instruments. But has the understanding of what drives financial markets and what is the appropriate valuation for markets improved?  I would like to say yes, but my experience tells me that the answer is no. Technology has vastly increased the amount of information available to market participants, but the understanding of the importance of various different pieces of information seems no better than it was in 1929, 1974, 2000, 2008 or times in between. In fact, the huge increase in the amount of information available may only serve to obfuscate the information of real importance, as markets react to red headlines and systematic asset managers are programmed to react in the same way as in the past or to follow the crowd. An increase in the volume of information only reduces the impact of the information that is of real importance if the market assigns some importance to every piece of information. Or in other words, the more information there is the more possible reasons there are to justify any given market valuation. Thus, the 2000 dotcom bubble found a reason for a wildly out of line valuation, and there were enough greedy investors and trend followers to send equity markets to stratospherically silly levels.

So much for philosophy. What’s the relevance to today’s markets? I wrote recently about the low valuation of European equities (see “A huge opportunity”), and I stick by that view. Some have come back to me worrying about low European growth, Italian banks, Cocos, European immigration, populist movements, but this seems to me to miss the point. There are always risks and concerns, but they have to be evaluated relative to the things that matter for value – in the case of equities this means growth prospects, the initial level of  earnings and dividends, alternative investments (interest rates), and risk premia, which is a bit of a catch all and can be used to justify almost anything, but a sensible view tells me that risks now are less serious than they were at the height of the Greek crisis.

For currencies the metrics are different, and although most of the time the markets are dominated by risk on/risk off trades, it makes little sense to think of currencies moving in this way over the long run. Real currency levels are ultimately anchored to fairly static long run valuation measures, unlike equities which rise over time with nominal growth. Relative growth rates can certainly matter for currencies, not least because they affect relative interest rates, but in the developed world there is actually relatively little long term divergence in growth rates, especially when adjusted for population growth. This isn’t really that surprising, as in the developed world technology and capital is very mobile, and it is hard for one country to show a sustained superior growth performance. Most of the time, better growth is temporary, and comes with a price, usually a bigger current account deficit, as is currently clear in the UK. Changes in the terms of trade – as can be seen with the big move in the oil price – will of course have a long term impact, but I distrust debt fuelled growth (and any growth that is generating an unsustainable current account deficit is debt fuelled from a whole country perspective) as long run reason for currency strength. Sooner or later (admittedly usually later) the positive currency impact of stronger growth and higher rates is reversed either by the need to rein back on growth to control the current account or inflation or the budget, or by others catching up.

What does this have to do with history repeating for GBP? Well it’s a roundabout way of saying that the strong pound, the growing UK current account deficit (and indeed twin UK deficits) are a repeat of a long history of similar episodes in post war UK economic history. The strength of the pound won’t last and we are headed for either a slow or a fast decline in the pound, depending on whether the UK stays in the EU (staying will hold GBP up) and whether the world economy picks up (if it does the decline in GBP will be slower). But the period of UK and GBP outperformance is hitting traditional current account buffers. Sure, UK won’t have to go cap in hand to the IMF this time as in 1976, and a fading of Brexit fears may trigger a GBP rally of sorts. But whatever the politicians agree, the risk of a vote to leave will remain, and more importantly, the underlying economics doesn’t justify a stronger pound, or even as strong a pound as we have now in the longer run. With even McCafferty accepting that UK rates aren’t going up, EUR/GBP is a buy on the dip, even if the ECB cut again as is widely expected and add to QE. Look for 0.85 this year in EUR/GBP, possibly 0.95 if things go badly on Brexit.

 

EUR/GBP rally – if not now, when?

After flirting with the 0.75 area for a few days, EUR/GBP has pushed through on this morning’s weak industrial production data and has potential to start making real ground to the upside. Technically, there are some reasons for caution. Although last week saw a strong weekly close at the highest level for a year, we have had seven consecutive up weeks and the weekly channel top at 0.7525 hasn’t broken convincingly. But, if not now, when?

GBP has been overvalued for a long time, most particularly against the EUR, it’s largest trading partner. It is also a lot more overvalued than it looks, for two reasons. Firstly, because UK inflation has been much higher than inflation in other major economies since the financial crisis. While inflation has recently been subdued, CPI in the UK has risen 10% more than CPI in the US or the Eurozone since 2008. So 0.75 now is equivalent to 0.68 in 2008 in real terms. Secondly, the UK is running a current account deficit of 6% of GDP – the largest in the developed world – while the Eurozone is running a surplus of 3% of GDP. While the UK deficit has come about mainly because of declining UK investment income rather than a rising trade deficit, it won’t be closed by improved export performance at this level of GBP. Historically, current account positions DO matter for valuation over the long run, and the widening of the UK deficit suggests to us that long run fair value for EUR/GBP is more like 0.85 or 0.90 than 0.75.

But this has been the case for some time Why should GBP suffer now?

  1. The long awaited UK rate hike still seems to be disappearing into the distance as wage growth stalls, so those looking to buy GBP on yield spread grounds have little support in the short run.
  2. GBP has already fallen a long way against the USD, and while it may fall further, yield spreads between the US and Europe have also stalled or narrowed of late as US data has slightly disappointed since the Fed rate hike, so there seems limited downside for EUR/USD from here in the short run, suggesting at least as much GBP downside potential against the EUR
  3. The EU referendum question. The possibility of Brexit is clearly negative for GBP and while I personally think there will be a strong majority in favour of staying in the EU, the foreign investment that the UK needs to funds its current account deficit is unlikely to be too enthusiastic while the question is in the air.
  4. Policy wise, there is nothing the government or the Bank of England would like more than a weaker pound. They will never try to force it, but I wouldn’t be surprised to see a little verbal encouragement of GBP weakness.
  5. A weak oil price is more supportive for the Eurozone than the UK, given the Eurozone is a much bigger net oil importer.

By the time we get to the referendum (maybe June) I expect we will already have seen the big decline in GBP, and we may see a recovery after the referendum if, as I expect, we get a vote to stay in. The recovery may start before the referendum if it looks like the “remain” campaign is going to win easily. There is no time like the present for the GBP bears to get the ball rolling.