jamestomlins_100

A tool for a rising rate environment: high yield floating rate notes

We are entering a new era for interest rates in the developed world. The extended period of ever looser monetary policy is starting to draw to a close. In the wake of the tapering of quantitative easing (QE) from the Federal Reserve (Fed), investors now expect to see the first interest rate hikes in many years, initially in the UK and shortly afterwards in the US. The principal focus of the debate is over the questions of “when?” and “how fast?” interest rates should rise, not “if?”. For bond investors in particular, this transition has thrown up a lot of difficult questions. Having benefited greatly from falling yields and tightening credit spreads, the move to a more hawkish cycle will create many more headwinds and challenges when it comes to delivering returns for many fixed income asset classes.

Consequently, any instrument that can help investors navigate this environment has rightly been receiving a lot of interest and attention. In the latest in our series of the M&G Panoramic Outlook, we will focus on one such instrument, the high yield floating rate bond. In recent years, this instrument has gained popularity with many issuers and the market has grown to a total US$44 billion.

A high yield floating rate note (FRN) has two key defining features: (1) a floating rate coupon that is automatically adjusted in line with changes in interest rates; (2) a relatively high credit spread that reflects the additional credit risk of a non-investment grade issuer.

It is the combination of these two features which not only enables investors to receive an attractive income stream now, but also allows them to benefit from higher coupons should interest rates increase with no associated loss to capital. This last element, the lack of a hit to capital in a rising interest rate environment, is the key difference to the traditional universe of fixed coupon bonds which suffer from price declines as yields move up.

In this issue, we will take an in-depth look at the characteristics and make-up of the high yield floating rate bond market. We will also consider the key drivers of returns, as well as some of the risks and how these can be managed.

anthony_doyle_100

What could possibly derail the global economy?

Things are looking pretty good for the global economy right now. The U.S. Federal Reserve is slowly reducing quantitative easing, China is continuing to grow at a relatively rapid pace, the Bank of England is talking about rate hikes, and the central banks of Japan and Europe continue to stimulate their respective economies with unconventional and super-easy monetary policy. The International Monetary Fund expects growth in the developed economies to pick-up from a 0.5% low in 2012 to almost 2.5% by 2015, while emerging market economies are expected to grow by 5.5%.

Of course, it is notoriously difficult to forecast economic growth given the complexity of the underlying economy. There are simply too many moving parts to predict accurately. This is why central banking is sometimes described as similar to “driving a car by looking in the rear-view mirror

With this in mind, it is prudent to prepare for a range of possible outcomes when it comes to economic growth. Given the consensus seems pretty optimistic at the moment, we thought it might be interesting to focus on some of the possible downside risks to global economic growth and highlight three catalysts that could cause a recession in the next couple of years. To be clear, there are an infinite range of unforeseen events that could possibly occur, but the below three seem plausibly the most likely to occur in the foreseeable future.

Risk 1: Asset price correction

Every investor is a winner

There is no question that ultra-easy monetary policy has stimulated asset prices to some degree. A combination of low interest rates and quantitative easing programmes has resulted in fantastic returns for investors in various markets ranging from bonds, to equities, to housing. Investors have been encouraged by central banks to put their cash and savings to work in order to generate a positive real return and have invested in a range of assets, resulting in higher prices. The question is whether prices have risen by too much.

This process is likely to continue until there is some event that means returns on assets will be lower in the future. Another possibility is that a central bank may be forced to restrict the supply of credit because of fears that the economy, or even a market, is overheating. An example of this is the news that the Bank of England is considering macro-prudential measures in response to the large price increases in the UK property market.

In addition, there is a surprising lack of volatility in investment markets at the moment, indicating that the markets aren’t particularly concerned about the current economic outlook. Using the Chicago Board Options Exchange OEX Volatility Index, also known as the old VIX (a barometer of U.S. equity market volatility) as an example shows that markets may have become too complacent. Two days ago, the index fell to 8.86 which is the lowest value for this index since calculations started in 1986. Previous low values occurred in late 1993 (a few months before the famous bond market sell-off of 1994) and mid-2007 (we all remember what happened in 2008). The lack of volatility has been something that several central banks have pointed out, including the U.S. Federal Reserve and the Bank of England. The problem is, it is the central banks that have contributed most to the current benign environment with their forward guidance experiment, which has made investors relaxed about future monetary policy action.

If these events were to occur, we could see a re-pricing of assets. Banks suffer as loans have been given based on collateral that has been valued at overinflated prices. A large impact in currency markets is likely, as investors become risk averse and start to redeem assets. These events could spill over to the real economy and could therefore result in a recession.

Risk 2: Resource price shock

Energy prices could hamper economic growth

It appears that the global economy may be entering a renewed phase of increased volatility in real food and fuel prices. This reflects a number of factors, including climate change, increasing biofuel production, geopolitical events, and changing food demand patterns in countries like China and India. There may also be some impact from leveraged trading in commodities. There are plenty of reasons to believe that global food price shocks are likely to become more rather than less common in the future.

As we saw in 2008, these shocks can be destabilising, both economically and politically. In fact, you could argue that the Great Financial Crisis was caused by the spike in commodity prices in 2007-08, and the impact on the global economy was so severe because high levels of leverage made the global economy exceptionally vulnerable to external shocks. Indeed, each of the last five major downturns in global economic activity has been immediately preceded by a major spike in oil prices (as the FT has previously pointed out here). Commodity price spikes impact both developed and developing countries alike, with low-income earners suffering more as they spend a greater proportion of their income on food and fuel. There is also a large impact on inflation as prices rise.

A resource price shock raises a number of questions. How should monetary and fiscal policy respond? Will central banks focus on core inflation measures and ignore higher fuel and food prices? Will consumers tighten their belts, thereby causing economic growth to fall? Will workers demand higher wages to compensate for rising inflation?

Risk 3: Protectionism

After decades of increased trade liberalisation, since the financial crisis the majority of trade measures have been restrictive. The World Trade Organisation recently reported that G-20 members put in place 122 new trade restrictions from mid-November 2013 to mid-May 2014. 1,185 trade restrictions have been implemented since October 2008 which covers around 4.1% of world merchandise imports.  Some macro prudential measures could even be considered a form of protectionism (for example, Brazil’s financial transactions tax (IOF) which was designed to limit capital inflows and weaken the Brazilian currency).

If this trend is not reversed, trade protectionism – and currency wars – could begin to hamper economic growth. Small, open economies like Hong Kong and Singapore would be greatly impacted. Developing nations would also be affected due to their reliance on exports as a driver of economic growth.

Many economists blame trade protectionism for deepening, spreading and lengthening the great Depression of the 1930s. Should the global economy stagnate, political leaders may face growing pressure to implement protectionist measures in order to protect industries and jobs. Policymakers will need to be careful to not repeat the mistakes of the past.

Economic forecasting is a tricky business. It is important that investors are aware of these risks that may or may not eventuate, and plan accordingly. The outlook may not be as rosy as the consensus thinks it is.

richard_woolnough_100

Deflating the deflation myth

There is currently a huge economic fear of deflation. This fear is basically built on the following three pillars.

First, that deflation would result in consumers delaying any purchases of goods and services as they will be cheaper tomorrow than they are today. Secondly, that debt will become unsustainable for borrowers as the debt will not be inflated away, creating defaults, recession and further deflation. And finally, that monetary policy will no longer be effective as interest rates have hit the zero bound, once again resulting in a deflationary spiral.

The first point is an example of economic theory not translating into economic practice. Individuals are not perfectly rational on timing when to buy discretionary goods. For example, people will borrow at a high interest rate to consume goods now that they could consume later at a cheaper price. One can also see how individuals constantly purchase discretionary consumer goods that are going to be cheaper and better quality in the future (for example: computers, phones, and televisions). Therefore the argument that deflation stops purchases does not hold up in the real world.

The second point that borrowers will go bust is also wrong. We have had a huge period of disinflation over the last 30 years in the G7 due to technological advances and globalisation. Yet individuals and corporates have not defaulted as their future earnings disappointed due to lower than expected inflation.

The third point that monetary policy becomes unworkable with negative inflation is harder to explore, as there are few recent real world examples. In a deflationary world, real interest rates will likely be positive which would limit the stimulatory effects of monetary policy. This is problematic, as monetary policy loses its potency at both the zero bound and if inflation is very high. This makes the job of targeting a particular inflation rate (normally 2%) much more difficult.

What should the central bank do if there is naturally low deflation, perhaps due to technological progress and globalisation? One response could be to head this off by running very loose monetary policy to stop the economy experiencing deflation, meaning the central bank would attempt to move GDP growth up from trend to hit an inflation goal. Consequences of this loose monetary policy may include a large increase in investment or an overly tight labour market. Such a policy stance would have dangers in itself, as we saw post 2001. Interest rates that were too low contributed to a credit bubble that exploded in 2008.

Price levels need to adjust relative to each other to allow the marketplace to move resources, innovate, and attempt to allocate labour and capital efficiently. We are used to this happening in a positive inflation world. If naturally good deflation is being generated maybe authorities should welcome a world of zero inflation or deflation if it is accompanied by acceptable economic growth. Central banks need to take into account real world inflationary and deflationary trends that are not a monetary phenomenon and set their policies around that. Central bankers should be as relaxed undershooting their inflation target as they are about overshooting.

Under certain circumstances central banks should be prepared to permit deflation. This includes an environment with a naturally deflating price level and acceptable economic growth. By accepting deflation, central banks may generate a more stable and efficient economic outcome in the long run.

markus_peters_100

Bundesbank: no deflation in sight. Really?

Today I came across an article in which the Bundesbank took the festive season as an opportunity to discuss if all the Christmas sales discounts are going to turn into a permanent phenomenon for the Eurozone. “No deflation in sight” (in German) concludes that the Eurozone is unlikely to experience continuously falling prices, ie deflation. The Bundesbank does however identify some parallels between today and the 1930s – the last period of deflation in Germany. The Bundesbank attributes the current disinflationary trend in the Eurozone to the austerity imposed on the peripheral economies. It is striking that this line of argument offers the opportunity to draw some historical parallels. In the early 1930s, chancellor Brüning’s retrenchment policies (in form of emergency decrees) in response to the global economic crisis and the perceived lack of German competitiveness included severe wage cuts for civil servants, public sector job cuts, reduction of pension payments and entitlements as well as higher income taxes.  These policies marked a period of severe economic downturn and deflation with major historical consequences.

Germany’s economic downturn in the early 1930s

However, the Bundesbank seems to take some comfort out of the fact that the deflationary experiences in the periphery have not been as severe as in Germany in the 1930s and not sufficient to drag the entire Eurozone into a deflationary spiral so far. The German central bank anticipates that the austerity measures will show their positive effects on the peripheral economic competitiveness soon which should pay off in form of a return to modest economic growth in 2014 and 2015. While the high unemployment rates in the Eurozone, and in the periphery in particular, will continue to ease any inflationary pressure, the paper concludes that the pickup in economic activity will provide an anchor to the downside. In other words, the worst is over, and that’s why there is no deflation in sight. SocGen’s Sebastien Galy critically points out that the Bundesbank bases much of its analysis on the assumption of a strong positive correlation between growth and inflation which historically has not always been evident and doesn’t seem to be consistent with the trend of disinfloyment that the US is currently experiencing.

Two different monetary policy approaches during economic downturns and periods of austerity

The Bundesbank also sees the deflation risk contained in the Eurozone as the ECB’s monetary policy response is very different to the 1930s. Back then, the economic downturn was aggravated through the monetary policy response of the Reichsbank. As the chart above shows, the central bank kept interest rates at a very high level which led to unbearable financing costs in the real economy and suppressed credit growth further. The reasons for this policy approach were certainly very complex, but, without delving too deep into any academic debate, it seems that the German room to manoeuvre might have been restricted by the Young Plan and that the shock of hyperinflation in the 1920s built a psychological barrier to loose monetary policy. The Bundesbank article points out that today’s monetary response by the ECB is very different. Today’s historically low ECB refinancing rate of just 0.25% is a reflection of the ECB’s very expansive monetary policy approach in response to the Eurozone crisis and is, therefore, providing another anchor of price stability, i.e. reducing the downside risk of deflation.

However, the psychology of deflation doesn’t get sufficient focus by the Bundesbank in this particular article in my view. The authors touch upon the concept of inflation expectations and their impact on consumption behaviour (if you expect prices to go down, then you delay purchases which puts further downward pressure on prices), but don’t go into much detail. As the latest M&G YouGov Inflation Expectations Survey showed, expectations were still well-anchored in November, but on a declining trend across Europe, and it will be interesting to see how inflation expectations have adjusted considering that recent data showed that not only did the periphery experience real wage declines in the third quarter, but German workers also saw real wage declines for the first time since 2009. This is certainly a surprising, if not worrying trend with regard to both disinflation and the Eurozone rebalancing efforts.

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jim_leaviss_100

US Treasuries – are we nearly there yet? Maybe we are.

Before we get all beared up about tapering, it’s worth seeing how far we’ve come already, and what the end game should be. The sell-off in US Treasury bonds has already been severe. 10 year yields have risen from a low of 1.4% in July 2012 to nearly 3% today. Most street strategists have yields rising further in 2014, with the consensus 10 year forecast at 3.37% for a year’s time.

But as well as looking at the spot yield, we should see what the yield curve implies for future yields. The chart below shows the 10 year 10 year forward rate – in other words the expected 10 year UST yield in a decade’s time backed out mathematically by looking at long dated UST yields today. You can see that the implied 10 year yield is now over 4%, at 4.13%.

The other thing I have put on the chart is a shaded band representing the range of expectations within the Federal Open Market Committee (FOMC) for the longer run Federal Funds rate. You can find this range of expectations here on the third slide of the charts from yesterday’s FOMC minutes. Four members think that that the long run Fed Funds rate is as low as 3.5%, and two think it is as high as 4.25%. The median expectation is 4%.

The bond market expects 10 year USTs to yield 4.13% in a decade’s time

Now the 10 year bond yield is effectively the compounded sum of all short rates out to 10 years, plus or minus the term premium (which we will discuss in a minute). If the FOMC members are correct that 4% is the long run interest rate, then if the term premium is zero, the 10 year forward rate at 4.13% has already overshot where it needs to be, and we should be closing out our short duration positions in the US bond markets.

The term premium is important though (this blog from Simon Taylor is good at explaining what it is, and showing some estimates). The term premium is compensation for the uncertainty about the short rate forecast. Historically it has been positive, as you might expect, reflecting future inflation or downgrade risks. In recent years though it has been negligible, even negative – perhaps due to a non-price sensitive buyer in the market (the Fed through QE), but also perhaps due to deflation rather than inflation risk? It is likely however that the term premium rises at a turning points in rates – and also that if inflation ever made a sustained comeback, with central banks refusing to fight it, like in the pre-Volker years, the risk premium would rise strongly. We also know that markets tend to overshoot in both directions. Nevertheless, whilst it’s too soon to say that we’ve seen the highest yields of this cycle, as a value investor you could say that yields are moving towards fair value.

ben_lord_100

Disinfloyment – the state of strengthening labour markets and falling inflation

Whilst I was listening to Ben Bernanke last night, who announced his decision to reduce the monthly rate of purchases of treasuries and mortgage backed securities by $10 billion per month, it became clear that the time has come to coin a new phrase. With the employment picture improving substantially in the last few months from a very weak point, and with GDP growth moving in a similarly positive direction from a similarly weak point, it is entirely justifiable in my opinion that the Fed continues to provide historically vast quantities of liquidity, albeit at an ever so slightly slower pace. The Fed sees growth returning to between 2.8% and 3.2% for the next couple of years, and it sees unemployment falling to between 5.5 and 5.8% within that horizon. Take a step back, briefly, and you would look at these predictions for the economy and expect the policy rate to be substantially higher than zero. So why did Ben Bernanke spend so long anchoring the market’s expectations for the future path of interest rates, and why is he still creating $75 billion of cash each month?

In the 1970s the more economically developed nations were experiencing an unexpected new phenomenon: low employment and high inflation. This, as we all now know, came to be known as stagflation. Today, the US, and just very recently the UK, is experiencing the opposite: rapidly improving employment and falling inflation. I am going to call this disinfloyment.

Chairman Bernanke said that low inflation is “more than a little concern”. One has to think that it was the improving economic and political picture, as well as perhaps some concern over early bubble formations, that brought about the decision to taper, on the one hand, and the inflation picture that brought about the strengthening forward guidance and lowering and weakening of the unemployment rate ‘knockout’ on the other. Otherwise, given a better broader economic outlook, you would expect a truer normalisation of policy, with the provision of liquidity being stopped and rates being hiked. The concern I think Bernanke has, and the question I would have asked him, would have been “what if zero interest rates, massive liquidity provision, and forward guidance do not manage to generate inflation at or above target? What then Ben?”

If the Fed were to find itself in a position of full employment, acceptable growth, and disinflation, with policy rates and long term interest rates near their extreme floors, and the efficacy of increased liquidity provision being increasingly marginal of benefit, or perhaps worse, then the Fed is alarmingly close to the limits of its powers. Perhaps only helicopter drops would remain a viable tool at this point. It is the awareness of this that I think is framing current Fed action. At 1.5% 10 year treasury yields earlier this year, rapid liquidity provision, and zero interest rates, there was almost nothing the Fed could do to counteract falling inflation; it simply couldn’t add much more stimulus. The utterance of the ‘t’ word in May, and now the first minor reduction in the pace of stimulus last night has seen 10 year yields rise to 3%, and from this point there is scope for data to disappoint to such an extent that yields fall, forward guidance is pushed out further, and QE can be increased so as to stimulate the economy.

So disinfloyment is a state of the economy that policymakers are rightly very scared of, as, depending on the economy’s starting point, it is a state in which economic policy is getting ineffective. But do I actually think that this is a term that we will hear more of in the next couple of years? Probably not.

For disinfloyment to become a problem, the employment picture must continue to improve, and inflation must continue to fall or fail to rise. Whilst I believe the former to be highly likely at this point, I find that latter harder to believe, and the Fed’s projection yesterday was for inflation to return to 1.4% to 1.6% in 2014. Whilst this is clearly still below target, it is less worryingly so than it is today. Bernanke told us yesterday that he presently sees the glide-path for tapering to continue at $10 billion at each meeting, until liquidity provision stops at the end of 2014. I believe that there is a very difficult line for the Fed to tread over the next 12 months. As tapering continues and the markets come to expect the end of the stimulus, long-term yields will rise (as we saw in the Summer) and the economic data risks going in the wrong direction for the tapering to continue. For a gradual rise in rates not to detrimentally affect the recovery, the economy must be growing with such underlying momentum as to shrug off these higher rates: and in this environment, surely inflation would be returning? So: either the Fed finds the recovery to be too fragile to continue tapering, in which case it continues to increase the supply of money each month, thereby risking higher inflation further into the future when the economy improves; or the recovery is sufficiently strong, and inflation (excluding commodities, which the Fed cannot control) is rebounding.

Markets are being staggeringly complacent about inflation at the moment, aided by presently low inflation in the developed world. We would do well to remember that monetary policy since the start of the Great Financial Crash has been designed with one major purpose: to avoid the spiral of deflation witnessed in the 1930s. Deflation, clearly the greater evil of the dichotomy, has been avoided so far. But now developed economies are recovering, liquidity-driven positions are coming back out of commodities and emerging markets, which are pushing down inflation numbers around the world. 2014 will be treading a fine line between these disinflationary forces prevailing, and so monetary policy having to re-start the liquidity machines, and recoveries managing their ways through this transition and finding underlying momentum. Respectively, we either continue to risk higher inflation further in the future through increasing the supply of money, or we start to see it come through sooner than we all presently think: either way, we get inflation. Lest we forget: the Fed will have increased the supply of money by $4.25 trillion at the end of the tapering cycle. When the velocity of money starts rising on top of the increases in money supply, nominal output will start to rise unless the money supply is taken out to an offsetting extent. It is this that I find so unlikely, and it is this that would increase the probability of disinfloyment. In my opinion, we are more likely to get nominal output surprises, and so returning inflation, than anything else in the UK and US. We won’t hear too much, at that stage, about disinlfoyment.

anthony_doyle_100

Jim Leaviss’ outlook for 2014. The taper debate (watch the data), inflation (where is it?), and it’s a knockout. Merry Christmas!

With many expecting a ‘great rotation’ out of fixed interest assets in 2013, bond investors will, in the main, have experienced a better year than some had predicted 12 months ago. It might not always have felt like it at the time – indeed, over the summer when markets were sent into a spin by the prospect of the US Federal Reserve (the Fed) cutting its supply of liquidity earlier than expected, it almost certainly did not. But riskier assets, notably high yield corporate bonds, have continued to perform strongly, while investment grade corporate bonds are on track to deliver another year of positive returns, in spite of the volatility.

Meanwhile, the macroeconomic backdrop has generally improved over the past year, with the economic recovery gaining significant momentum in the US and, more recently, the UK. However, the picture in Europe remains mixed, while our concerns over the emerging markets are mounting. However, despite their disparate prospects, all countries – and all bond markets – are united by at least one common dependency: the Fed.

So what does 2014 have in store for global bond markets? In our latest Panoramic outlook, Jim outlines his macroeconomic and market forecasts for the year ahead. And for those of you who have been wondering, the annual M&G Bond Vigilantes Christmas quiz will be posted later this week.

Enjoy!

stefan_isaacs_100

Eurozone inflation surprises to the downside. ECB will grudgingly be forced to cut rates.

Last week saw year-on-year core inflation in the euro area fall from just over 1% in September to a two year low of 0.7% in October (see chart). Such a level is entirely inconsistent with the ECB’s definition of price stability as inflation “below but close to 2%”, and will likely be met with a downward revision to medium term inflation prospects and with it an ECB rate cut later this year.

Slide1

The ECB will no doubt have monitored the recent steady appreciation of the euro (see chart), which has effectively acted as a tightening of policy and will likely have a disproportionately negative effect on the periphery. Coupled with the latest inflation data, the strengthening of the euro will no doubt increase calls from the doves on the Governing Council (who should be acutely aware of the rising risks of a Japanese-style deflationary trap) to run a more stimulative policy.

Slide2

With little evidence of upward pressure on German wages, the internal devaluation required within the eurozone to facilitate a more competitive and balanced economic area has also been dealt a blow. Richard recently noted an improvement in euro area funding costs, and with it a stabilisation of broader economic data. However, this is from a very low base and the challenges that Europe continues to face should not be underestimated. Both unemployment and SME funding costs remain stubbornly high in the periphery and non-performing loans continue to move in the wrong direction (see chart). The ECB understandably wants to maintain pressure on politicians to deliver on structural reforms, and no doubt some harbour fears of leaving fewer policy tools at their disposal once they cut rates towards zero, but the risks of medium term inflation expectations becoming unanchored to the downside should be a wakeup call and a call to action!

Slide3

richard_woolnough_100

Mortgage intervention – the UK government’s unconventional attempt to ease monetary policy

Since we started writing these blogs almost 7 years ago we have spent an understandably great deal of time discussing Bank of England monetary policy in the UK, initially with regard to conventional interest rate policy and now in the context of the unconventional policies we see today.

The most recent unconventional twist for monetary policy is not emanating from the Bank of England itself, but is effectively coming directly from the government. The Help to Buy home ownership scheme is a direct attempt to make the monetary transmission system more effective, with its supporters claiming it is a way to get free markets working so that good borrowers can access appropriate funding, while its detractors claim it’s stoking a housing boom and fuelling the next crisis.

One of the ways that monetary policy in the UK works is through the housing market. Interest rate changes reduce the cost of financing, which increases disposable income, or allows an individual to own a larger house for the same mortgage payments. This creates immediate wealth via higher disposable income, economic activity via the associated services and goods consumption that occurs with house moves, and a wealth effect as house prices rise.

It has been pretty plain that the connection between official interest rates and rates available in the real world has broken down during the financial crisis, as the banking system has been repressed from a capital, confidence, and regulatory point of view. The authorities have tried to counteract this by providing capital, encouraging the raising of capital, and providing huge amounts of liquidity. However, the traditional mechanism of rates feeding into the real economy in the UK via the housing channel was limited.

The Help to Buy and other schemes such as Funding for Lending are attempts to mend the disconnect between official rates, the banking system, and the real economy. Therefore they should be welcomed as an attempt to make monetary policy work again. This unconventional policy appears to be working. The UK housing market is strong. This week’s RICS survey showed that home sales in September reached a near four year high and the market is improving across the country, not just in London. As the chart below shows, there is potential for further strength in the future too, with sales expectations for the next three months reaching new highs.

RICS Sales Expectations at multi-year highs

My next chart shows 2 year fixed mortgage rates plotted against 2 year swap rates. As you can see, although swap rates plummeted from late 2008, when official interest rates were slashed in the height of the credit crisis, these falls were not passed on to the same degree in the real world through mortgage rates. But they are now becoming slowly more aligned, as swap rates have been gradually rising recently and mortgage rates continue to fall. This is obviously good for the housing market and the economy. This effect is about to get bigger as the availability of low deposit mortgages should provide a strong boost to all the activity associated with housing.

Mortgage rates are slowly reducing

Why has it taken so long to introduce this unconventional measure? It could have been a reluctance to stoke the housing market following the last crash, a belief that these kind of non-standard measures would not be needed, or it could be that it has been timed now in an attempt to push the economic cycle in line with the UK political cycle. The latter seems to be a consequence of the measures. They have been introduced in time to boost the housing market and the economy, and are set to expire before the election to encourage a rush of buying, as occurred with the removal of mortgage interest tax relief in the 1980s.

The UK economy looks set to be strong in the run up to the election as the disconnect between official rates and real activity gets resolved. The liquidity trap is being solved by government action. For better or worse, the UK housing market is going to be at the centre of UK economic activity once again.

jim_leaviss_100

A little less conversation and a little more action. Gilts underperform and sterling rallies when the BoE speaks

“Now, much has been made of the upwards movements in market interest rates since our announcement of forward guidance and I would like to give you my perspective. There’s been a generalised upward movement in long term bond yields, across the advanced economies, including the UK, over the course of the past month.  The main common driver is speculation that the US Federal Reserve will soon reduce the pace of its asset purchases (and) …. liquid sovereign bonds of the world’s largest economies are close substitutes for each other”.

Bank of England Governor Mark Carney in the “Jake Bugg” speech, Nottingham, 28th August.

In other words, according to Mark Carney, gilts sold off because treasuries sold off. Personally I do not share this view, and feel some of the blame also lies with the Bank of England. Indeed, if we look at the aftermaths of the 4 occasions of Carney writing or talking about forward guidance (the August Inflation Report, the Nottingham Speech, the BoE Monetary Policy Committee Meeting, and at the Treasury Select Committee), we see that in each instance the pound appreciated markedly and gilts underperformed.

Put together, the result so far of forward guidance has therefore been a tightening in UK monetary policy – Governor Carney said last week that monetary policy has become more “effective” as a result of guidance.  Perhaps, but only if you thought the UK was overheating, and this does not appear to be his, or other MPC members’, position.

7th August: the Inflation Report is published.

The August Inflation Report contains the forward guidance that the Chancellor commissioned in the Budget.  It said that rates would be no higher than 0.5% until unemployment was down to 7%, and that the Asset Purchase Facility wouldn’t shrink.  But it contained the three killer knockouts – that you could ignore forward guidance if the Bank’s forecast of inflation rose to 2.5%, if market/consumer inflation expectations became unanchored, or if there were risks to financial stability as a result of low rates. The market focused on these knockouts rather than the unemployment promise. Sterling rallied and gilts underperformed both US Treasuries and German bunds.

Carney intervention 1 - Quarterly Inflation Report

28th August: the Nottingham speech.

There was no mention of the famous knockouts in this speech and the tone tried to be dovish.  But there was a repeat in both the performance of the currency (a rally) and the gilt market (an underperformance).  These same trends are also exacerbated when the Bank of England’s MPC makes its “no change” rate/QE announcement on 5th September without any attempt to reinforce the commitment to forward guidance.

Carney intervention 2 - Nottingham speech

Carney Intervention 3 - BoE MPC Meeting

12th September: the Governor and MPC members appear in front of the Treasury Select Committee.

Not so strong this one – there was a reaction initially from sterling, and to a lesser extent gilt spreads.  But they weren’t especially long lived.

So I have no sympathy for Mr Carney’s view that forward guidance isn’t working because of the adverse movements in the pesky international bond markets – gilts have underperformed both bunds and treasuries, and the appreciation in the pound suggests that the markets think that Carney’s central expectation of three years without a hike is wrong.   But in the Nottingham speech, Mr Carney also suggested that another explanation for rising gilt yields is that “the markets think that unemployment will come down to 7% more quickly than the Bank does…that would of course be welcome”.  This is credible.  We look at economic surprise indices, and it is clear that around the time of the publication of the August Inflation Report, the UK economic data started to not only surprise on the upside, but to be even more upwardly surprising than the (also better than expected) economic data coming out of both the Eurozone and the US.  It’s a combination of the lack of clarity around the knockouts (made worse at last week’s TSC – I recommend you go along to watch this live if you get the chance by the way) and an expectation that the Bank’s unemployment forecast is overly bearish.  Of course the rise in international yields is important, but it’s not the full story.

Carney Intervention 4 - Carney faces TSC

UK economic data stronger than in US and Europe

So the timing of sterling rallies and gilt underperformance around the time of Bank communications suggests that they ARE getting something wrong, and the grilling in front of the TSC did not go well.  If I were them I wouldn’t try to use open mouth policy to try to reverse the trends we’ve seen, as it could lose them more credibility were the markets not to react positively.  Doing something is another matter though, and could lead to a big reversal in the gilt and currency markets.  As UK economic data improves and surprises on the upside I doubt we’ll see anything yet – but we do need a little less conversation and a little more action.

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