Category Archives: Monetary policy

Bias at the Bank?

First of all, let me declare my own view on Brexit, in case anyone thinks what follows represents my own bias (which it may do but I’ll be up front about it). I am voting to stay in the EU, but as much for political/emotional as economic reasons.

Having said that, I believe Carney was showing bias in his positive view of the EU at the Treasury Select Committee hearing yesterday. One reason was presented by Jacob Rees-Mogg, who questioned his statistical arguments as being speculative, and I think that is right, as even Carney admitted that many of the points arguing that the EU had helped boost capital inflows and growth were “arguable”.

But even if that is wrong and you can make a strong statistical argument for membership of the EU having boosted growth and investment in the past, there is no guarantee that that will be the case in the future. Past performance, as Mr Carney should know if he reads the small print to investment advice, is not necessarily a guide to the future. The EU now is different to the EU in the past. Whether being a member is positive for growth and investment will depend to some extent on the arrangements Britain makes with the EU but also on the EU itself and whether it can shake off its persistent economic malaise of recent years . I would agree with the “Remain” campaign that the benefits from leaving are currently pretty nebulous in terms of the things that we would no longer have to do to comply with EU law as it stands, but the terms in the future could change and “ever closer union” could mean an increasing EU straitjacket on the UK.

Now Mr Carney would no doubt argue that he was making no claims for the future but rather just producing the evidence available. Well, yes, but the choice to do so is in itself a decision. Bias is about the questions you ask as well as the answers you give. If you ask the right questions you know you will get the answers you want.

To be fair to Mr Carney, he did say that the decision on Brexit was not purely an economic one, though conveniently that statement justified him providing a pro-EU view with the economic analysis and still being able to claim he wasn’t taking a position on Brexit.

Carney also said that he had not discussed what he was going to say with David Cameron. But since it is part of the Bank’s remit to support the government’s economic policy and maintain financial stability a pro-EU view is almost prescribed. There is little doubt that Brexit would create uncertainties in the short term, even if the impact on markets is more unpredictable than most claim, and the short term could turn out to be quite short.

So in this case, I agree with Jacob Rees-Mogg. It would have been better for Carney to have been far more scrupulously neutral. Not that many voters probably care much what he thinks. After all, while the previous BoE governor Lord King has also said he is not expressing a view on Brexit, his recent comments have been very negative about the Eurozone and could be seen to favour the “Leave” camp, even though he makes it clear that Britain is inextricably linked to the EU regardless of the decision. And while Lord King isn’t everyone’s cup of tea, he will at least still be living here after the referendum, and is  deeply rooted in the UK and has also experienced the whole period of EU membership, the ERM debacle, the financial crisis, etc., and is not beholden to any government or political party. I would suggest his views consequently carry rather more natural weight.

 

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Cheer up Mr Draghi

The Eurozone economy is a long way from being healthy, so it’s understandable that the market remains inclined to believe in more ECB easing at the March 10 meeting. I’m not going to go too far into the details of what the market expects, but a rate cut of 10bp or more and an increase in QE both now seem pretty much expected, along with possible tiering of deposit rates to limit the impact on banks. Of course, last time  market went in with this expectation is got a bloody nose, with the ECB only producing a  10bp cut in the deposit rate in December, so positioning is likely to be a little more cautious this time around. But the ECB do seem less likely to disappoint the market this time, both because of less committed market expectations and because Mr Draghi will be very conscious of the risks of a EUR rally if he fails to produce a significant easing.

But while that may be what they will do, I’m not at all sure it’s what they should do. The ECB’s behaviour is looking to me to be increasingly overactive and is starting to look panicky, which seems to me to be creating rather than relieving concerns about the economy.  It’s true that here has been a manufacturing slowdown since the last meeting, but no more so than elsewhere – indeed rather less so than in the US. PMIs have dipped but still indicate slow growth – we are not back in recession. Inflation is a little lower than expected or desired, especially the latest February number, but inflation can be quite volatile on a month to month basis and it is rash to make major policy decisions based on one month’s number. After all, while the market was disappointed by December’s easing, it is still the case that the ECB did ease as recently as December.  Two easings in 3 monthswould suggest some need to panic, and I don’t think that’s a story the ECB should be telling. While they eased twice in 3 months in 2014, it was against the background of a very strong exchange rate. This time around, they have a weak exchange rate and inflation is being significantly subdued by a weak oil price. Core inflation dropped to 0.7% in February, but was 1% in January which was above where it was when they eased in 2014.That monetary conditions are being eased further even though the outlook looks better than in the past may reflect policy having bee too tight for too long, but this perma-easy stance with a hair trigger for further easing carries its dangers.

Firstly, there seems little reason to believe that a further ECB easing will have any significant impact. The ECB themselves indicate that loan growth is improving already and the pass through from any further exchange rate weakness is unlikely to be very large given the weakness of emerging market currencies. What the region could do with is an expansion of fiscal policy from those that can afford it (Germany). A modest deposit rate cut, especially if it is tiered to protect banks (and by implication savings rates) will have minimal impact. Secondly, the ECB seems to me to be underestimating the value of promoting confidence. A more upbeat assessment of the economy and an indication that they have some belief that the (substantial) policy measures already put in place were taking effect and would continue to take effect in the coming months would have a more positive impact. Gloom and doom and a further monetary easing both undermines confidence and takes the pressure off government to do anything on the fiscal side.

None of this means the ECB won’t ease next week. Indeed, the risk of market disappointment now means they probably need to given the expectations that have built up, in large part because of ECB rhetoric. But it would sensible if this time around Draghi emphasised some of the positives rather than indicating the potential for further action. Sensible because he is probably not going to be able to squeeze anything more out of the hawks on the committee anyway, unless there is clear evidence of a dive into recession, and even if he could it would be unlikely to have much impact. An attempt to build some confidence and perhaps encourage governments to take their share of the burden would, I think, be more effective than threats of ever more negative rates.

GBP weakness just beginning

There is certainly some risk premium in GBP related to concerns about Brexit, but it’s hard to see why this will disappear. Given that the market is still betting on a 65-70% chance that the referendum will produce a vote to stay,  based on the betting exchanges, it is hard to see the risk premium even diminishing much in the run up to the vote. If the Scottish referendum vote is anything to go by, the full risks may not be priced until quite close to the poll, which is now set for June 23. Of course, there is some GBP weakness related to heavy buying of out of the money put options, which we can see in the big skew in the options market, but these are also unlikely to be unwound anytime soon. Indeed, if anything the risk is surely that the odds of Brexit move closer to 50-50 as we approach the referendum, increasing the pressure on GBP. Personally I expect the UK will vote to stay in, but this is unlikely to be felt with any real confidence until much nearer the vote (or possibly not until after it). Incidentally, Brexit concerns should probably be best expressed by short GBP/USD or GBP/JPY as Brexit is bad for the EUR as well as GBP (albeit not as bad).

So Brexit risks still look to be to the downside for now. How about other factors? Many would argue that the relative strength of the UK economy is still a potential GBP positive, and that the focus on Brexit has only temporarily suspended the market’s demand for GBP based on a strong economy and relatively attractive interest rates (at least relative to the Eurozone). However, there are several problems with this view.

First of all, spreads are not that attractive. Sure, it looks like Brexit has created some risk premium, but 2 year spreads (swaps) have narrowed from 1.1% to 0.9% this year. The latest MPC testimony to the Treasury select committee suggested a split committee, but one where the possibility of a rates cut and/or more QE was being considered by at least 3 members (Carney, Vlieghe, Haldane) if the economy were to take a turn for the worse. Given the zero bound is not yet a factor for the UK curve, there is a lot of potential downside for UK yields in this scenario. Even so, I wouldn’t base a negative GBP view on declining yield spreads. The UK data is still reasonably robust, albeit with some weak patches, and I feel the evidence of global weakness has been somewhat overstated, with emerging markets looking much more pressured than developed markets. This may change, but for now I wouldn’t get overexcited about the scope for a UK rate cut, and the UK curve is probably pricing too dovish a view. Nevertheless, until global sentiment improves, a return of the prospect of UK rate hikes can’t be seen as a supportive factor for GBP.

But even if we take a positive view of the prospects for the UK economy and interest rates, and even if Brexit concerns don’t increase, I would argue that the upside for GBP is very limited because of the two problems of valuation and the UK current account deficit (and related budget deficit). While valuation is rarely a big factor for currencies in the short term, it is significant at extremes and the chart below of the GBP real effective exchange rate underlines that the pound is still at high levels even after the latest decline. The real trade-weighted index is still only around 10% off 2008 highs, and some 20% above 2009 lows, while in nominal terms the story is the other way around (20% off the highs, 10% off the lows), disguising the true extent of GBP strength.

gbppic

Source: BIS

But the other main consideration is the fundamental issue of the UK current account and its significance for GBP. Like valuation, the current account tends not to be a focus in developed countries in the short run, but over the long run there is  strong correlation between the current account position and a currency’s valuation. Countries with big current account surpluses tend to have currencies that trade well above Purchasing Power Parity (PPP), while those with big deficits have currencies that tend to trade below PPP. The big deterioration in the UK current account in recent years suggests it should be trading further below PPP. According to the OECD, GBP/USD PPP is 1.42 based on GDP. Given that the US has a much healthier current account and higher yields this should be seen as a ceiling, even assuming no Brexit risk. The OECD estimate of EUR/GBP PPP for GDP is a more dramatic 0.92! Given that the Eurozone is running a current account surplus of 3% of GDP while the UK has a deficit of 6% of GDP this suggests GBP is extremely expensive against the EUR from a longer term perspective. Relatively high UK yields  justify some GBP strength but only extremely negative EUR sentiment has kept GBP strong in recent years. The other implication of the relative current account positions is that while relatively strong UK growth has made UK yields more attractive, it has also sucked in imports and means the UK has a growing current account gap to finance. Strong growth funded by borrowing from abroad is not the formula for a strong currency longer term.

The conclusion is that even if the UK avoids Brexit and even if next UK move in rates is up, the still high level of the pound suggests there is more GBP weakness to come, possibly in the shape of a traditional UK balance of payments crisis.  More likely, the tightening of UK fiscal policy will restrict the current account deterioration and preclude the need for higher interest rates for some time, but this will not mean a GBP recovery, only a slower decline.

Riksbank – still crazy?

I apologise to those who aren’t interested in Sweden – I have harped on about it quite a lot and now I’m going to do so again. If you have no interest look away now.

Today sees the Riksbank monetary policy meeting with the result announced tomorrow. The median market expectation is that the Riksbank will cut rates even further into negative territory, and this is no doubt part of the reason why the SEK remains weak. Now, applying logic to the behaviour of the Riksbank may be foolhardy, as real rates of -1.25% for a country growing at near 4% real seems odd to start with, but I can see no good reason for them to cut rates. Sure, the equity market has been weak and the oil price has fallen since the last meeting, but if you are going to react to monthly moves in these markets you will be changing rates every meeting. It is not clear that these moves will either be sustained or that they will have a significant impact on inflation.

The key factors in the decision seem to me to be as follows:-

  1. Is there evidence of a weakening in the Swedish economy or a loss of confidence? No. The economic tendency survey – the best short term indicator of GDP – rose again in January and is at the highest level since 2011.  
  2. Is inflation or inflation expectations falling back to problematic levels?                    It’s too early to say. December CPIF Inflation was a little weaker than expected in the December monetary policy report at 0.9%, against the 1.1% projected, but is projected to rise sharply in January. This data isn’t out until next week. Inflation expectations remain little changed according to surveys.
  3. Is the exchange rate too strong?                                                                                         No. After strengthening sharply around the turn of the year, the SEK has weakened in the last few weeks to the lowest level since late December (based on the KIX index that the Riksbank use). It is in line with the Riksbank projected path and much weaker than they would have expected a few weeks ago.
  4.  Is there a need to cut rates for other economic reasons?                                                   No. Quite the opposite, as credit growth remains strong and the Riksbank continues to highlight the risks related to excessive household indebtedness.
  5. Will other central banks cut rates leading to SEK strength?                                        Quite possibly, and this is probably the best reason to expect a Riksbank rate cut at some point. However, with the Riksbank highlighting the possibility of intervention  to control currency strength, there is less reason to expect them to use rates if there aren’t other reasons for a rate cut. The ECB may well cut rates next month, in which case the SEK may well strengthen, but there is no need to pre-empt this, as the outcome is unknown. The Riksbank may allow some currency strength or may choose to try and control it with intervention rather than a rate cut.

All in all, I see no reason for the Riksbank to hurry into a rate cut. Of course, they have shown a recent history of extreme dovishness, but the strength of the economy, high household indebtedness, strong credit growth and their apparent willingness to use intervention to control the currency if necessary suggests to me there is no intention to move unless inflation clearly weakens significantly. Surely it is better to wait until they have the January inflation data and have seen the ECB action and the currency reaction? A cut now would be a panic measure related to market turmoil. It is of course possible (most people are forecasting it) but that makes the minority view of no change all the more attractive for SEK bulls like myself.

Don’t get fooled again

Since my last post on here, we have had ECB and Fed communications. While Draghi managed to sound concerned enough about the recent data and weak inflation outlook to send EUR/USD down around 1.5 figures, and get about 80% of analysts looking for a deposit rate cut in March, the Fed statement was only marginally more dovish than last time, downgrading domestic demand growth to “solid” from “moderate”. Both expressed some concern about weaker energy prices and the effect on inflation and inflation expectations, and about weaker exports.

In the end, EUR/USD is back where it was before the ECB meeting, but it seems to me the economic assessments being offered here are a little topsy-turvy. Has there really been much change in the Eurozone picture since December? Sure, the January business and economic climate indicators have dipped to the lowest since August, but then December was the high of last year, so the level isn’t particularly worrying, and sentiment may well have been affected by the equity market tumble at the beginning of the year rather than anything concrete. Inflation is a little weaker than expected, but essentially because of lower oil prices, and these have now bounced a bit.

Draghi’s downbeat assessment in January “heightened uncertainties regarding developments in the global economy, as well as to broader geopolitical risks. These risks have the potential to weigh on global growth and foreign demand for euro area exports and on confidence more widely.”

Draghi’s downbeat assessment in December  “heightened uncertainties regarding developments in the global economy as well as to broader geopolitical risks. These risks have the potential to weigh on global growth and foreign demand for euro area exports and on confidence more widely.”

So these aren’t really new concerns, and while a strong majority seems to think they cut the depo rate in March, it seems a bit previous to assume this given pretty limited data, and given the fairly implacable opposition from the conservative wing of the ECB last time. cCan the market really take the same stance as last time after getting so badly burnt? Not without more convincing data would be my view.

In the US, the data has been fairly universally disappointing including today’s durable goods report, but manufacturing is especially weak. Employment is, however, holding up, though the market never seems to acknowledge that employment is typically a lagging indicator. Tomorrow’s Q4 GDP release is expected to come out at just 0.8% annualised – that’s 0.2% in q/q European terms. The Fed seems fairly immune to the weakness of the numbers, partly because they tend to get revised a lot, but on the basis of the numbers alone there really isn’t a case for thinking about another rate hike in H1. If employment growth ever catches up with this growth weakness in a real way we can forget about another hike this year.

In summary, it’s early days, but right now I can’t see why the market would want to hold long USD positions against pretty much any of the majors. If you are looking for growth we’re not seeing it in the US – you are much better looking at Sweden. The long USD position is already well held on rate expectation grounds, so there is a limit to the USD’s safe haven appeal if growth is weak everywhere. The JPY or EUR would make more sense. But EUR/USD and USD sentiment are supertankers, so we may not see immediate USD weakness, and the higher EUR/USD goes the bigger the chance that the ECB do act, so EUR upside is likely to prove a bit of a struggle. But if the oil price continues to rally, the case for more ECB easing will be hard to make. So coming into the next ECB meeting – don’t get fooled again.

Unreliable boyfriend/Inflation nutters

Carney has in the past been cast as an “unreliable boyfriend” for blowing hot and cold and not really letting people know where he stands. I have to say this is a bit more true after today, as his emphasis on the weak aspects of the economy – noting the weakness of China as a factor – rather contrasts with his performance at the Treasury Select Committee a few months ago when he played down the weakness of China as something the Bank had already factored into their forecasts. Of course, he has to represent the views of the committee, but I don’t think there’s enough real change in the news in the last few months to justify a real change in the Bank’s thinking.

The conclusion is that listening to Carney is a mug’s game. In any case, I’m a fan of the market trying to make up its own mind about things, and it had essentially already priced a fairly distant rise in UK rates. Carney’s following rather than leading, and GBP was already under pressure, the marginal rise in inflation today notwithstanding. Regular readers will know I see plenty of good reasons for GBP weakness anyway. So EUR/GBP going to 0.77+ looks fair enough to me with 0.78 my short term target. But at these levels I’d be less keen to open new GBP shorts, especially against the USD, as a lot of the bad news is now in, unless we get more clarity on the risks around the UK EU referendum. Nevertheless, longer term, I still like EUR/GBP at 0.85+

The Riksbank are inflation nutters. That looks to be the conclusion of the report by former Bank of England governor Mervyn King and economist Marvin Goodfriend commissioned by the Riksdag Finance committee and published today. King was the one who coined the term as a description of central bankers who were too closely focused on near term inflation and missed the bigger picture. The report urges more flexibility and recommends that the Riksbank’s 2% inflation target should be measured by consumer price inflation at constant interest rates or CPIF, which is not affected by changes in mortgage rates, which seems obvious to anyone thinking seriously about the issue.

The report makers say it is “striking” that the members of the Executive board devoted so much time to thinking about the future path of the repo rate and to providing guidance as to their views on how it should evolve over the following three years.

“There is something surreal about the precision of the guidance provided by individual board members as to the future path of the repo rate when contrasted with the sheer uncertainty about the future and the fact that markets took rather little notice of the published path in determining their own expectations,” the report says.

In fact, I think the market has taken more notice of the Riksbank than the authors accept, especially recently. What should be the result of this report is that there is less focus on the immediate inflation outlook and consequently less Riksbank obsession with the level of the currency. And the market should feel more freedom to ignore the Riksbank’s repo rate projections. All of which should mean there is less reason to expect them to cut rates again or intervene given the strength of the real economy. Net result should be a substantially higher SEK.

ECB? BoE? No – Swedish CPI

There will be a lot of focus on the ECB and Bank of England monetary policy meetings and press conferences and minutes on Thursday, but frankly I can’t see much of interest coming out of either. The ECB has only just announced its latest easing, so can’t really be expected to do anything or say a great deal. Inflation is a touch lower with the oil price, but not so much that it changes the long term view, and the economy continues to perform OK.

For the BoE, there isn’t much reason for anyone to change their view, though McCafferty could decide to fold short term on his rate hike call, but even if he does it doesn’t make a lot of difference. Clearly the manufacturing data has softened, and growth in general may be slowing a touch, so policy is on hold. I doubt they will say anything that significantly changes market pricing for the first UK rate hike. If they had any sense, they would try to talk GBP down a bit in the minutes. Although in reality the recent weakness of manufacturing probably has very little to do with the overvalued pound, a weaker pound wouldn’t hurt, and in bringing inflation up would allow a rate hike at some point which would be good for the balance of the economy. I’m not holding my breath expecting a GBP collapse on the minutes, but it seems to me that’s the risk if there is one.

But all this is really just hot air. Swedish CPI for December looks more interesting to me. The Riksbank have been resolutely talking down the SEK and threatening all manner of measures to stop it going up too fast, essentially because they have an inflation target and worry that a stronger SEK will kill progress towards it.Frankly, I think their stance is bonkers, as recent experience of inflation targeting has shown that trying to target it too closely is likely to be unsuccessful in the short run and counterproductive in the long run. The Swedish economy grew at about 4% in 2015 and is expected to do the same in 2016. Inflation being 1% below target (and rising) is not a big problem. The SEK will have to go up sooner or later. Best to let it go up when the economy is in shape to deal with it.

Still, rightly or wrongly the Riksbank has it’s inflation blinkers on, so a weak number on Thursday will get everyone thinking they might cut rates again. I doubt it myself, but it would probably be enough to send EUR/SEK to 9.30 or so. Conversely, a strong number would allay some of the low inflation concerns, and send it to 9.20. I doubt the Riksbank would get involved with their threatened intervention this side of 9.20, and probably not before 9.10 if inflation is stronger. Risks are probably towards a weaker than expected number rather than a stronger one, but I’m a buyer of SEK on the dip, as it’s only as low as it is because people are worried about Riksbank action, and they won’t do anything if the currency dips.