Peter Pan, Central Banks and markets

J M Barrie’s Peter Pan had a very strong grasp of the necessity of faith – “Whenever a child says “I don’t believe in fairies”, there’s a fairy somewhere that falls down dead” was written in 1911, and his own ability to fly was critically dependent on his lack of doubt that he could fly.

Ever since the introduction of QE in 2009, markets have had faith that the unconventional actions of the Central Banks would lead to economic recovery. The markets’ expectation of better times ahead itself played a key role in boosting confidence in the real economy, so helping to generate that recovery.

In the last three months however, that faith has been eroding as markets have come to believe that central banks are no longer in control of events. In Japan, the failure to boost QE further at the end of 2014, when the Bank of Japan were expected to do so, closely followed by the adoption of negative interest rates a week after denying they would do so looks like panic. In Europe, Draghi encouraged markets to believe that further ECB easing would be forthcoming in December, only to be unable to deliver it, and then repeated the encouragement that action would be taken in March after market weakness in January. The ECB appears to be a very divided Central Bank. In the US, the Federal Reserve clearly indicated in December when it raised interest rates for the first time in seven years that it expected four further such increases in 2016. Yet markets now assign an equal probability to their next move being a rate cut as a rate hike – the Fed is losing credibility.

Behind all this is the continued deterioration in growth expectations – a year ago there was a general sense that 2015 would see economic recovery around the world as the enormous global monetary easing over the previous six years finally bore fruit. The reality was that once again growth disappointed expectations even with the tailwind of a much lower oil price. Market sentiment is giving up on monetary policy producing economic recovery, and their lack of belief will make it even harder for Central Banks to deliver it.

In particular the move to negative interest rates in Europe and Japan, and the admission by Janet Yellen that the Federal Reserve would also do so if they believed it was necessary has alarmed investors in bank securities, both equities and bonds. Coming as it does with further downgrades to global growth expectations, markets have drawn the implication that central banks themselves are losing confidence that further QE will stimulate economies and thus they are moving towards the idea of negative interest rates. If the Central Banks no longer believe in QE, why should anyone else?

Widespread negative interest rates have not been adopted before – perhaps they will incentivise people to spend rather than save, but that is unclear. What is clear is that negative interest rates are bad news for banks – they have been very reluctant to extend negative interest rates to most depositors, with the result that their net interest margins are falling, at a time when loan growth is slow or non-existent. Banks are the worst performing equity sector so far in 2016.

Markets have now lost faith in the ability of Central Banks to create economic growth – falling bond yields and falling equity prices demonstrate this. To recapture that faith, Central Banks will have to take even more aggressive, unusual and unexpected action.

Forgive us our debts!

An open letter to Messrs. Osborne and Balls

Dear George and Ed,

Are you seeking a policy that you can surprise markets with on the first day after the General Election, just as Gordon Brown managed when he made the Bank of England independent in 1997, that you cannot talk about ahead of the election, but has no cost and will probably boost your chances of winning the 2020 election?

Well here it is – tell the Bank of England to cancel all the government bonds it has bought through its QE policy intervention in financial markets. I am sure your advisers have already produced papers looking into this for you. Obviously if one of you announces it before the election, the other will denounce it as dangerous and totally irresponsible but I think it works for whichever of you is Chancellor in May.

The Bank of England bought £375bn of gilts in their quest to support the UK economy between 2009 and 2012, which represents about 25% of the total gilts outstanding and about 23% of UK GDP. Since the Bank of England is an arm of the UK government (though acts independently when setting monetary policy) then these gilts represent debt that the UK owes to itself – each year the government pays interest on these gilts to the Bank of England, which books the interest as income and can be used to pay a dividend back to the government. On the national balance sheet, the gilts are an asset of the Bank of England but a liability of the government, and so cancel each other out. Although when QE was originally announced in 2009, it was expected to be temporary and would be unwound (ie the gilts sold back into the secondary market) when policy was to be tightened again, it is now clear that this remains a long way away and policy tightening will initially be implemented through interest rate increases. These gilts will be held for a long time.

The advantage to you in cancelling these gilts is that the ratio of debt to GDP falls from around 90% of GDP to around 70% of GDP and the UK balance sheet suddenly looks much healthier in absolute terms and compared with the major European countries as well as the US and Japan. The pressure from being an economy with too much debt disappears and gives you as politicians much more flexibility in how rapidly you need to deal with the debt. Further, ahead of the 2020 election you will have lots of very attractive charts showing that the UK has much less debt than all those around – what a sound economy the UK will seem to be!

What are the downsides? – well, the Bank of England will technically be bankrupt since the value of the bulk of its assets fall to zero, but that doesn’t matter because it can then print the money it needs to rebuild its capital base. This will enable to others to say that it represents pure money printing on a permanent basis, which may be argued to be hugely inflationary and risky. But this has been the case for almost 6 years now with QE and there are still no signs of these inflationary risks – all that is happening is that the pretence that QE will be reversed has been taken away. Also it does rather suggest that the Bank of England is not actually independent of the government – however, since the financial crisis it is very clear that governments and central banks around the world have been working together rather than independently of each other – central bank independence is a convenient illusion.

A bold act to start the next government which costs nothing to implement and provides lots of advantages to you ahead of the next election – what’s not to like?

Kind regards,

Jeremy

The Global Monetary Policy Kaleidoscope

In 2009, in the face of a global economic crisis, the major economies of the world came together and acted in concert to ease monetary policy aggressively.  Together with fiscal stimulus in the US and China, these policies helped to prevent the world from slipping into depression.  Four years on, the economic conditions around the world vary enormously, and the appropriate monetary policies are now very different (though for all countries fiscal restraint is deemed necessary).  These differing monetary policies are producing clear differences in how the local financial markets are performing, and in 2013 there has been a much greater dispersion of performance between equity markets around the world than in 2012.

The economy with the most aggressively easy monetary policy (relative to the size of its economy)  is currently Japan, where in response to the lead of the new Prime Minister, the new Bank of Japan Governor has begun a programme of doubling the country’s monetary base in just two years.  This is being done deliberately to raise the rate of inflation in Japan from the negative rates seen in recent years to the new target of 2%.  To bring Japan out of its 20 year deflation, policymakers have articulated that inflation, and inflation expectations, need to rise to boost the nominal growth rate of the economy.  Should the current policy settings not be sufficient to do this, it is expected that policymakers will move monetary policy to an even easier stance.  The weaker yen that is likely from this policy should be instrumental in helping to boost inflation.

Next is the US, where currently the QE programme is about $4bn of new money creation every day that the financial markets are open.  Before the latest Japanese policy move, this constituted the most aggressive monetary easing.  However, the recent furore following Bernanke’s comments about the tapering of the QE policy indicate the sensitivity of markets to changes in the direction of US monetary policy.  Bernanke tried to argue that tapering a policy of printing $4bn every day to one of printing $2bn or $3bn was still a very accommodative policy; the markets however appeared to interpret it as a tightening of policy.  The rise in US bond yields since May shows that a policy that is easy, but less easy than it was, creates different expectations in the minds of investors, and the Federal Reserve’s words have thus changed the thinking of investors.

Both the ECB and the Bank of England are at a similar phase in their monetary policy.  Both have pursued unconventional policies in the past, the ECB with their three year LTROs and the Bank of England with their own QE programme, but have done little recently to move policy easier.  However, the new Bank of England Governor has clearly been tasked with boosting economic growth in the lead-up to the next election, and the ECB is concerned about the continued poor performance of the Eurozone economy.   The recent rise in bond yields that began in the US and spread across the Atlantic has been unwelcome as it raises the cost of borrowing for business and so offsets the otherwise easy policy in both the UK and the Eurozone.  A further easing of monetary policy can therefore be expected from both Central Banks, and crucially, for markets, the direction of monetary policy is still moving easier, in contrast to the US.

In China, markets have been surprised by the actions of the People’s Bank of China in not providing sufficient liquidity for the interbank market to operate smoothly in the face of liquidity pressures.  This caused overnight interest rates briefly to move above 10%, and has been interpreted as a lesson to the banking system that they have been too carefree with their lending and need to cut back.  This is effectively an act of policy tightening, though it is unlikely that the Chinese will take such tightening too far and seriously damage the economy’s growth prospects.

Finally, there are a number of significant emerging markets such as Brazil, Turkey, Indonesia and India where Central Banks have actually raised interest rates or have indicated an intention to do.  For the most part, this has been due to currency weakness, which boosts inflationary pressures in these economies, and so a tightening of monetary policy is believed to be required, in contrast to most of the rest of the world.

The league table of the stance of monetary policy, which runs from Japan, the US, the UK, Europe, China and Asia and then other emerging markets correlates precisely with the league table of year-to-date equity market performance.  Those countries with the easiest stance of monetary policy are those whose stock markets have performed best, and those with the tightest policy stance have performed worst.  This highlights the increasing dependence of financial markets on the liquidity provided by Central Banks, rather than fundamental economic and earnings trends.

Looking forward, we would expect Japan to remain at the top of the easy monetary league, with the UK moving up and the US moving down in the next few months, and the Eurozone having little room to make any changes.  China’s slowing growth will eventually produce an easier monetary policy, but may not be imminent, while the other emerging markets appear to be the furthest away from easier policy.  Japan and Asia remain the most favoured markets in our portfolios with Europe and Emerging Markets the least favoured.

Changes to the UK Retail Prices Index – implications for index-linked gilts

The UK’s Office for National Statistics (“ONS”) has announced a consultation on a proposal to change the way it calculates the Retail Prices Index (“RPI”). For the last few decades, in the minds of the British public this is believed to be the best measure of inflation in the economy. This has been reinforced by the introduction in the 1980s of index-linked bonds, which are government bonds offering inflation protection by indexing both capital and income payments by the change in the RPI. In addition, many private sector pension schemes have pensions which rise in line with the RPI, and many regulated industries have their pricing models set by regulators which are linked to the RPI. The RPI is a key part of the fabric of British life.

Sadly, the ONS believe that it is, statistically, a rather poor measure of inflation (as described later). In 1996, all EU members were required to calculate their inflation measures on a consistent basis – this index is the Consumer Prices Index (“CPI”), and being of a much more modern construction, this is the measure now preferred by the government for setting its inflation objective to the Bank of England (“BoE”), and state pensions and benefits are now linked to the CPI.

The RPI and CPI use the same price inputs each month, but a different statistical formula – this formula effect meant that historically the RPI tended to be 0.5% a year higher than the CPI. Thus, when Gordon Brown switched the BoE inflation mandate from an objective of 2.5% on the RPI, it became 2.0% on the CPI.

To illustrate this formula effect, consider a prices index, calculated monthly, with just two components, say strawberries and batteries over just two months. In both months the price of batteries is unchanged but the price of strawberries doubles in the first month and then halves in the second month. Over the two months combined, the geometric-weighted CPI will show that the rate of price inflation is zero, since all prices are the same as when the index began. However the arithmetic-weighting methodology of the RPI means that it will have risen and the rate of inflation will be deemed to be positive. Thus the RPI has an inherent upward bias compared to the CPI.

Since 2010 when changes to the RPI’s measures of clothing and footwear prices were made, the size of this formula effect has grown to almost 1.0% per year, and is in danger of creating mistrust in the statistics, which is why the ONS is seeking to change the methodology. Doing so would, however, have important effects on all those areas of British life which are referenced to the RPI.

In particular the expected returns of index-linked bonds (currently worth £280bn) would be 0.5-1.0% lower each year. At a time of very low government bond yields, this is significant. Should the BoE determine that the proposal amounted to a “fundamental change” that would be “materially detrimental” to the bondholders, then investors could, under the issuing terms of index-linked bonds,  demand their money back from the government. However, they would only be entitled to the par value of their bonds uplifted by inflation, which in general is well below their current market value.

The implications for markets are that by making this proposal the ONS has introduced a new risk factor for index-linked bonds that did not exist before – the measure of the rate of inflation used for returns may be lower than before. Ordinarily that should lead to lower prices. However, this news has come out at the same time as the Federal Reserve’s decision to engage in open-ended Quantitative Easing, which represents a clear shift in policy target away from controlling inflation and towards lower unemployment. This has boosted longer term inflation expectations in markets, and pushed up prices of index-linked bonds.

Index-linked bonds still provide investment portfolios with the most direct insurance against future inflation, but the effective payout on that insurance may be about to be cut. As with any insurance policy the balance between insurance premium, insurance payout and probability of payout has to be kept under review – recent events are tilting that balance away from having too much of this insurance in a portfolio. Globally, those investors who are not in countries with index-linked bonds have historically opted for gold as their inflation insurance.

 

UK Economic Policy – Sticking to Plan A (plus a bit)

Last week as investors worried about the Greek elections, the Spanish bank bailout and the Federal Reserve meeting, George Osborne and Mervyn King made significant announcements about UK economic policy. Since coming to power, the UK’s approach to managing the economy can be described as a slow but steady tightening of fiscal policy over the medium term, to avoid an austerity-driven recession as seen in parts of Europe, combined with an extremely easy monetary policy.

The complicating factor to this logical response to the UK’s problems was capital requirements that had been placed on UK banks following the banking crisis – much more exacting prudential requirements with regard both to capital and to liquidity risks had forced the banks into buying large amounts of gilts (UK government bonds). Whilst one side of this coin meant that banks’ balance sheets were better protected, the other side of that coin is a reduced emphasis on the attractions of lending to small and medium sized businesses, which is a vital but nonetheless risky activity for banks.

Mr. Osborne announced a scheme to offer both government guarantees and cheap funding for banks that lend to the domestic personal and small business sectors – at £80bn this is approximately 5% of total existing lending to these sectors. Mr. King announced that going forward banks would not have to hold such large amounts of liquid gilts on their balance sheets, and thus would be able to make more loans (which are less-liquid assets) to business. There are few details yet but assessments of how much this might mean are around £150bn.

These announcements are clearly aimed at allowing the QE policy to work more effectively, which until now has worked to inject lots of money into the financial system. However, little of it has found its way into the real economy – thus financial asset prices (in particular the price of gilts) have been supported but with only a small impact on growth. The banks are receiving very strong guidance that they should be lending.

There remain though both demand and supply problems with this new approach, which are likely to mean that it will have only limited success. First, with regard to the demand for bank loans, the banks consistently report subdued demand to borrow. Certainly the housing market is slow (apart from Central London, which is beset with Greek, Russian and Middle Eastern investors seeking a safe home for part of their wealth) – falling house prices is not an incentive to borrow heavily and a lack of confidence in employment prospects or future pay increases is endemic. Similarly the subdued state of demand that many small businesses face will mean that very few are seeking to borrow to expand. Where there is demand to borrow from small businesses, it is usually to cover slow trading (or poorer credit risks). On the supply side, the credit boom conditions of 2002-2007 is now over and banks are not prepared to lend on the optimism-fuelled terms that were available then. Instead, they are reverting to lending terms similar to those on before 2002, which feel now much more restrictive to businesses.

Osborne and King are sticking with Plan A, but trying to make sure more liquidity gets into the real economy. It will help at the margin to boost private sector growth as the public sector continues to be cut back, but the general desire of most people and companies is to reduce their debt rather than increase it. This combined with the major uncertainties within the European economies, will prevent a rapid recovery. There are risks to gilt prices since the banks are being told that they do not need to own so many gilts, but the prospects for UK equity prices are positive given their very low valuations and the (minor) benefits to growth of this adjustment in policy.

From Heroes to Zeroes – 21st Century Central Banking

At the beginning of this century, the reputation of Central Banks in the West was at its apogee – over the previous 20 years inflation had been wrung out of the global economy by maintaining interest rates consistently higher than the rate of inflation. If inflation threatened to rise too sharply then raising rates by a few hundred basis points was sufficient to choke off consumer demand (since their mortgage repayments formed such a significant part of their disposable income) and slow the economy and inflationary pressures. Once this had been achieved, often requiring a quick recession, rates could be cut again and the restoking of consumer demand would reignite the economy. In short, it was apparent that Central Banking that had as its main target the control of inflation could be successful at only a small cost to growth. Politicians found themselves able to give up their desire to control interest rates for electoral purposes and give independence to their Central Banks. Central Bankers became Heroes!

The recession in the US following the bursting of the internet bubble and fears for the US economy following 9/11 however, saw the Fed cut US rates right down to 1% in 2002 and hold them there until 2004. 1% interest rates were much lower than seen in previous cycles and in hindsight were responsible for a massive inflation of the US housing market. Whilst the internet bubble was essentially financed by equity, since the new companies had no cash flow, the housing bubble was financed by debt. Debt-financed bubbles we now know inflate far further than equity-financed bubbles and then burst in a far more devastating fashion. Central Banks meanwhile, focussing only on the Consumer Price Inflation targets did not spot the bubble in the debt markets and so did not increase interest rates sufficiently to manage things better.

Following the 2008 meltdown in the global financial system and subsequent recession, Central Banks found that even interest rates that were effectively set at zero no longer helped to boost consumer demand. This was for two reasons, first consumers realised that they had already got too much debt and no longer wished to borrow more, even with low interest rates and secondly the all economic agents (banks, companies and consumers) had lost confidence in the future growth prospects of the economy that they did not want to lend, borrow or spend.

The Central Banks went back to their old textbooks to search for policy tools when interest rates can no longer be reduced and discovered Quantitative Easing (QE) which pushes money into the financial system in an effort to boost the demand for financial assets and thus stimulate the real economy. Many Zeroes of dollars, euros, yen and pounds have been created in this way. QE has almost certainly worked in the sense that economic growth in 2009, 2010 and 2011 would have been much worse without this policy, but it has not been enough to boost growth back onto a sustainable path. Worse still, repeated applications of QE seem to be less effective at doing this than the first effort. The scale of these interventions has brought forth much criticism of Central Banks in the US and the UK for creating the risks of hyperinflation from the creation of so much money. In Europe where monetary orthodoxy of the Bundesbank is enshrined in the ECB’s mandate, the Central Bank is criticised (outside Germany) for not doing enough to support the Eurozone economy.

For politicians, who are policy-constrained by huge fiscal deficits and debts, the only hope is that Central Banks solve their problems, but whilst Central Banks have the tools for fighting inflation, they do not have the tools for fighting deflation. They have done what they can (zero interest rates and QE) but have little more to offer bar providing liquidity to keep troubled banks alive and adding more zeroes to the money supply. The Age of the Heroic Central Banker is now behind us.