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It’s a new dawn, it’s a new day. The ECB takes baby steps towards QE

Just when you thought the Fed had well and truly killed the carry trade, a surprisingly dovish Mario Draghi reminded markets yesterday that Europe remains a very different place from the US. Having previously argued that the ECB never pre commits to forward guidance, yesterday marks something of a volte-face. ‘The Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time.’ The willingness to offer guidance brings the ECB closer to its UK and US peers, the latter having been in the guidance camp for some time. This firmly reinforces our view that the ECB retains an accommodative stance and an easing bias.

The willingness to offer forward guidance to the market no doubt came after some long and hard introspection within the Governing Council. So why the change ? Firstly, the ECB is worried that it may miss its primary target of maintaining inflation at or close to 2% over the medium term. Secondly, Draghi indicated an increasing concern that the real economy continues to demonstrate ‘broad based’ weakness, and finally, as has been the case for some time, the Council worries that the Eurozone continues to labour with subdued monetary dynamics. This sounds increasingly like Fed talk of recent years.

Draghi also expressed his concern yesterday during his Q&A at the effective tightening of monetary conditions via higher government bond yields (see chart) since the Fed’s tapering discussions. Frankly the last thing the Eurozone needs at this stage in its nascent recovery is higher borrowing costs.

Bond yield have risen

Draghi in communicating that the next likely move will be an easing of policy has attempted to talk bond yields down. European risk assets appear to have taken his comments positively but the bond market remains sceptical. At the time of writing only short to medium dated bonds are trading at lower yields.

In conjunction with revising down its 2013 Italian GDP forecast from -1.5% to -1.8%, the IMF has publicly urged the ECB to embark upon direct asset purchases. Is this a likely near term response ? For now those calls will likely fall on deaf ears especially with German elections later this year. The ECB clearly believes that its next move would be to cut rates further in response to a weaker outlook. Buying time seems to be the current approach.

However, should Eurozone inflation expectations continue to undershoot (the market is currently pricing 1.36% and 1.66% over the next 5 & 10 years, see chart)  and economic performance remain downright lacklustre across Europe, then the ECB will have to think very carefully about what impact it can expect from a ‘traditional’ monetary response. QE may be some way off, and would no doubt see massive objections from Berlin, but in the same way that the ECB never pre commits, maybe just maybe, QE will be on the table sooner than the market is currently anticipating.

Inflation expectations in Europe


EM debt funds hit by record daily outflow – is this a tremor, or is this ‘The Big One’?

On Friday last week, EM debt funds saw a daily outflow of $1.27bn, which equalled the record set during the dark days of September 2011, a time when the Eurozone periphery and the ECB were particularly active bungee jumping down a precipice.   Outflows were even bigger on Monday this week, as EM debt funds were hit by $1.44bn in outflows.  The fact that Monday saw a daily record wasn’t much of a surprise; markets were violent, even by recent standards, with some Turkish bank bonds down 10% intraday at one point.   Outflows were a slightly less bad $1.07bn on Tuesday this week (the most recent data available), but that’s still $3.78bn of EM debt fund outflows in just three days.

The chart below plots the year to date daily flows in US high yield and EM debt, courtesy of EPFR.  Note that this data is for mutual funds only and doesn’t include flows from insurance companies, central banks etc, so while it gives you an idea of how grim the picture looks, it’s perhaps only 10% of the whole picture.  Note also that the EM debt asset class is significantly bigger than it was just two years ago thanks to a huge amount of debt issuance, meaning that although Monday saw a record outflow in absolute terms, it actually ranked number four relative to the size of the market.

EM debt funds hit by record daily outflow on Monday this week

Do the outflows matter?  EM debt bulls might argue no -  fund flows tend to lag market performance and flows have historically had little if any predictive power in forecasting future returns. The collective human instinct is always to buy at the top and sell at the bottom, and the losses in EM assets in the last seven weeks told you the outflows were coming.  Bulls might also argue it is comforting that EM debt outflows haven’t actually been bigger.  EM debt has seen the biggest drawdown since Q4 2008 – in the last 7 weeks the JP Morgan GBI-EM Index, a commonly used EM local currency sovereign debt index, has plummeted  13%, and the JP Morgan EMBI Global diversified index, a widely used EM sovereign external debt benchmark, has fallen over 10%.  Real money investors aren’t yet capitulating, which suggests that the huge inflows of the last few years are relatively sticky.

EM debt bears might look at it another way – in the context of the enormous inflows into EM debt in the last four years in particular, outflows haven’t actually been that huge, and yet returns have been abysmal.  One of the unintended consequences of much tighter bank regulation and balance sheet deleveraging is that market markers have reduced ability to warehouse risk, so relatively small changes in EM debt fund flow dynamics are causing far greater swings in market prices.   If outflows continue at this pace or worsen, then the effect on EM debt will likely be cataclysmic.

Are these outflows just a tremor, or are we witnessing ‘The Big One’?  To begin to attempt to answer that, it’s necessary to figure out what has caused such a violent sell off.  About a year ago I tried to explain that the reasons most people seem to buy EM debt – strong growth, good demographics, low government debt levels, an ‘under-owned asset class’ – are broadly irrelevant.   Thailand and Malaysia had great demographics in the mid 1990s, but that didn’t prevent the Asian financial crisis.  Ireland and Spain had very little government indebtedness prior to 2008, but that didn’t help much either. EM debt returns are instead largely a function of US Treasury yields, the US dollar, and global risk appetite, where the mix varies depending upon whether you’re looking at EM local currency debt, or EM external sovereign or corporate debt (see Emerging market debt is cool but you may be surprised what you find if you strip away the marketing myths for more).

The recent EM debt sell off appears to justify this view of the primary drivers of EM debt returns.  Market commentators’ explanation for the recent leg down in EM debt is Bernanke’s tapering talk, and this is clearly a factor.  Treasury yields have jumped, the US dollar has soared, and EM currencies have mostly slumped.  This is something that we had anticipated and were positioned for as explained in January, see Why we love the US Dollar and worry about EM currencies.

If you assume this EM debt sell off has all been about Fed speak, then I’d actually be much more comfortable about EM debt valuations now. EM bond yields have risen significantly faster than US Treasury yields, while EM currencies have generally fallen sharply, so EM debt valuations are obviously relatively more attractive now versus two months ago.   At the time of writing back in January, 10 year US Treasury yields were 1.8% and we believed they looked ripe for a correction.  Now, however, yields are above 2.5%, and yet the solid but unspectacular trajectory of the US economy hasn’t really changed that much.  Meanwhile US inflation expectations have in fact fallen considerably – for example the US 5 year 5 year forward breakeven inflation rate has slumped from 3% to 2.4%.  Jim discussed the US economy following a research trip in a blog earlier this month, see While the market gets excited about unemployment falling to 6.5%, the Fed’s attention is turning to falling inflation.

However, the recent EM debt move is unlikely to be all about Fed speak.  EM debt has been a stand out underperformer in the great carry sell off of the last two months, and dynamics in Japan and China are surely also important.  I believe that the behaviour of domestic Japanese investors is playing a greatly under-appreciated role.  In the early days and months of the much hyped but so far little-achieving ‘Abenomics’, every man, his dog, and his dog’s unborn puppies seemed to have gone long USD, short JPY, long risky assets and particularly long EM debt.  Some did it in a very leveraged way, and these trades have been a disaster since the beginning of May.  As mentioned in a blog a month ago, Japanese investors have in fact done the precise opposite of what every market participant seemed to think they would do. Below is an updated chart from a blog last month (see Japanese investors are not buying foreign bonds, they’re selling).  Japanese selling of foreign bonds has accelerated further recently, with the announcement overnight that there were ¥1.2 trillion of sales alone during the week to June 21st. Taking a rolling three month average, Japanese investors are selling foreign bonds at a near record pace.

Japanese investors have been selling foreign bonds not buying

It is the China dynamic that I find particularly worrying.  Commentators have focused on the drying up of Chinese inter-bank liquidity as demonstrated by spiking SHIBOR rates, although I think fears are overblown.  There is much speculation as to why SHIBOR has soared, the only additional observation I have is that spikes in SHIBOR are nothing new – I wrote a brief comment about a previous episode in January 2011, see funny goings on in Chinese banking sector.  There was a near replica of the current SHIBOR spike exactly two years ago, and while the SHIBOR moves this time around are particularly big, it’s hard to see why this time it’s different and the PBOC won’t supply liquidity.

A much bigger longer term China worry is that market participants still believe that China can grow at 7%+ ad infinitum, but I can’t see any scenario under which this is actually possible.  China’s wages have doubled since 2007 and its currency has appreciated 25% against the euro and 35% against the US dollar (based on spot return) since China dropped its peg in 2005.  Competitiveness has therefore significantly weakened.  Intentionally or unintentionally, the Chinese authorities have tried to hit an unsustainable growth target by generating one of the biggest credit bubbles that the world has ever seen.   If you add that an enormous demographic time bomb is starting to go off in China (eg see article from The Economist here), China’s long term sustainable growth must be considerably lower than consensus expectations.  Some believe the Renminbi’s destiny is to become a currency to rival the US dollar.  I think it’s more likely that opening up the capital account will encourage big capital outflows as domestic investors seek superior investment returns abroad (as an aside,  Diaz-Alejandro’s paper Goodbye Financial Repression, Hello Financial Crash offers some background on Latin America’s experience with financial liberalisation in the 1970s and 1980s).

My central thesis remains, therefore, that China will experience a significant slowdown in the coming months and years and this will have profound effects for global financial markets and EM debt in particular.  If you like clichés, China is in effect ‘turning Japanese’, but unlike Japan, it has grown old before it has grown rich. Rather than regurgitate the arguments, see blog from March (If china’s economy rebalances and growth slows, as it surely must, then who’s screwed?).  I continue to believe that EM and developed countries with a heavy reliance on exporting commodities to China are vulnerable, countries that are increasingly reliant on portfolio inflows from developed countries to fund their current account deficits are vulnerable, and those countries that tick both boxes (eg Australia, South Africa, Indonesia, Chile, Brazil) are acutely vulnerable.

In sum, EM debt now offers relatively better value than a few months ago, and it therefore makes sense to be less bearish on an asset class that we have long argued has been in a bubble.  That doesn’t mean I’m bullish.   The arguments put forward in September 2011 (see The new big short -  EM debt, not so safe) are more valid now than ever.  Foreign ownership of many EM countries’ bond markets has climbed higher (see chart below), and the EM debt outflows of the past few weeks are a pimple on an elephant’s derriere in relation to the decade-long inflows.  These inflows were initially driven by US investors fleeing the steadily depreciating US dollar, and more recently driven by European investors looking to park money outside the Eurozone.   Following the recent sell off, the vast majority of investors who have piled into EM debt in the last three years are underwater, and it will be interesting to see how they react.

Foreign ownership has increased enormously

The recent EM debt sell off probably isn’t yet ‘The Big One’, it is more a tremor.  ‘The Big One’ will probably need either US growth and inflation surprising considerably to the upside or China surprising to the downside.  If that happens then EM debt could really rumble, and these eventualities still don’t seem to be remotely priced in. It will take a much bigger sell off in EM debt, and specifically much higher real bond yields, before I’d turn outright bullish on EM debt and EM currencies.  Developed markets and specifically US dollar assets appear more likely to appreciate, and it’s ominous that previous periods of US dollar strength (1978-1985, 1995-2002) have been coupled with EM crises.


The M&G YouGov Inflation Expectations Survey

Today we have launched the M&G YouGov Inflation Expectations Survey with the aim of assessing consumers’ expectations of inflation over the short and medium term. There has never been a better time to gauge the views of consumers, with interest rates at multi-century lows, central bankers waist-deep in the experiment of quantitative easing and politicians wavering on whether or not austerity is the right thing to do. The report is available here.

Surveys of consumers’ inflation expectations are now a key component of monetary policy and there are a few in existence. However, our survey differs from existing surveys of consumer inflation expectations in a number of fundamental ways.

Firstly, it is the main survey of its kind to ask a consistent set of six questions to consumers in nine different countries across Asia and Europe. In total 8,000 consumers are surveyed on a quarterly basis by YouGov, the online market research company, in order to get timely and highly relevant results. Our consumer panels are weighted and are representative of the entire adult population of the country surveyed.

Secondly, by surveying consumers across the UK, Austria, France, Germany, Hong Kong, Italy, Singapore, Spain and Switzerland, policy makers and investors alike will be able to analyse how inflation expectations are changing over time across nine different countries. Importantly, the survey will also give a good indication of whether inflation expectations are becoming unanchored. If they are it could trigger changes in the nominal exchange rate, affect consumption and investment decisions, as well as wages and prices, and could cause inflation to persist above the target for longer than the central bank expects.

Finally, we have used best practice developed by the Federal Reserve Bank of New York in determining how we ask consumers about their inflation expectations. In late 2006, the Federal Reserve Bank of New York joined academic economists and psychologists from Carnegie Mellon University to assess the feasibility of improving survey-based measures of consumers’ inflation and wage expectations. The results of this project were announced in 2010 and can be viewed here. Interestingly, academic researchers found that there were a number of limitations in existing surveys.

For example, the Reuters/University of Michigan Survey of Consumers asks respondents to forecast changes in “prices in general” rather than changes in the “rate of inflation.” This wording, the researchers suggest, invites diverse interpretations and prompts many respondents to focus on price changes specific to their own experience rather than changes in the overall price level.

To address this limitation, the M&G YouGov Inflation Expectations Survey asks respondents to report their expectations for the annual rate of inflation in one year and five years from now rather than ask about prices in general. We also question respondents on whether rising inflation is a concern at the moment, how they think their net income will change in 12 months’ time, whether or not their central bank is pursuing the correct policies to meet its target of price stability, and whether their government is following the right economic policy. Importantly, this should allow us to gauge the public’s perception towards the credibility of central banks and governments.

The initial findings of the survey are shown below. The next report will be available in September.

Inflation expectations – 12 months ahead

Inflation expectations – 5 years ahead
The results of the May 2013 M&G YouGov Inflation Expectations Survey suggest that consumers in most countries surveyed expect inflation to be elevated above current levels in both one and five years’ time. In the UK, inflation is expected to be above the Bank of England’s CPI target of 2.0% on a one- and five-year ahead basis. All European Monetary Union (EMU) countries surveyed expect inflation to be equal to or higher than the European Central Bank’s CPI target of 2.0% on a one- and five-year ahead basis. All countries expect inflation to be higher in five years than currently, while four – Hong Kong, Italy, Singapore and Spain – anticipate it being equal to or higher than 3.0% in a year. Encouragingly, there are some signs of short and medium term inflation expectations falling from the levels reported in February in some countries.

We think that this report will be vital reading for central bankers, particularly as a time series is built up over the next couple of years which will allow us to monitor trends that may be developing. Ben Bernanke, Mark Carney, and Mario Draghi are all on the record stating how important inflation expectations are in achieving price stability and the economic benefits that go with it. It will also be highly relevant for both consumers and markets alike, particularly in a world where Central Bank Regime Change – where debt and unemployment rates become more important to central banks than inflation targets and price stability – is likely to occur. We aren’t there yet, but initiatives like the M&G YouGov Inflation Expectations Survey may be the bellwether that signals inflation expectations are becoming unanchored. And when that occurs, that is when central banks will face one of their toughest tests – trying to maintain their inflation-fighting credibility.


Video: whilst the market gets excited about unemployment falling to 6.5%, the Fed’s attention is turning to falling inflation

I spent a couple of days in New York last week seeing economists and academics. The US Treasury market had just seen a significant sell-off, with 10 year yields rising from 1.63% at the start of May, to over 2.2%, with much of the damage done by Bernanke’s surprise talk of QE tapering during the Q&A following his address to Congress’s Joint Economic Committee. US 30 year mortgage rates sold off in parallel, and are now around 4%, potentially damaging the housing recovery.

I came away with two main conclusions. Firstly, given the stuttering nature of the US growth recovery (and the second half of this year could be mediocre, thanks to some back-loading of fiscal cliff tightening) the case for a slowing of QE in the next few months is not at all strong. Economists point out that Bernanke’s prepared testimony to the JEC was very dovish and in no way suggested that tapering might happen this year. His Q&A response appears to have been a communication error, as evidenced by some rolling back over the last couple of days via well connected journalist Jon Hilsenrath in the Wall Street Journal. And secondly, whilst we all focus on the jobs data in the States and try to forecast the timing of hitting the 6.5% unemployment rate threshold, we might be taking our eyes off the Fed’s other concern, inflation. Having spiked higher in 2011/2012, thanks largely to higher commodity prices (cotton, oil), core inflation measures, and particularly the Fed’s preferred Core PCE Deflator statistic, are falling to around 1%. Wage growth is also weak. With inflation 1% below the target level, a Taylor Rule approach would see the Fed easing interest rates by 1.5%, not hiking or withdrawing monetary stimulus! And with rates at the zero bound and a cut impossible, unconventional monetary policy would have to take the strain. More, not less, QE might be more likely than any tapering.


Time gentlemen please: the Fed prepares its exit from QE

The punch bowl of easy money that the US Federal Reserve has offered the market has been significant over the last 5 years: from low rates, to quantitative easing and benign regulation. The purpose of the party was to keep animal spirits high and prevent the gloomy cycle of recession from turning into depression. This generosity has been mirrored around the world in different guises, and so far the policy has worked with varying degrees of success. The net effect has been to avoid economic depression.

Low interest rates and deficit spending have worked in the USA. The two charts below show the long term trend in US interest rates (wow what a party!) and the trend in unemployment, with the annotations showing how long after the peak in unemployment the Fed waited before hiking rates. This time around, not only has the volume of liquidity that has been served been record breaking, but the extent of the party, in terms of how long we have been sitting at the bar enjoying ourselves, has been remarkable compared to other cycles. Unwinding this is obviously going to pose some challenges.

US interest rates have been in a 30 year bull market

S unemployment continues to trend lower

Barman Ben Bernanke realises he is faced with this problem, as depression is now highly unlikely in his neighbourhood. The financial system is functioning, the housing market is in a new bull market, and unemployment is on a firm downtrend. The futures market is currently discounting the first rate hike from the Fed in early 2016, but growth could easily come in stronger than expected given the rebound in the housing market, which could also reduce unemployment faster than people anticipate (see Jim’s blog here for a discussion of how powerful the housing effect could be). So there’s a real risk that the Fed will have to move before the market expects. The attached chart shows that according to Unicredit, given the average pace of payroll gains over the past 6 months, the unemployment threshold could be reached as early as mid 2014, and possibly sooner if the housing market continues to strengthen.

Timeline for 6.5 unemployment under different scenarios

Given the jittery moves in the markets over the past couple of weeks on talk of tapering QE, Bernanke needs to decide how to wind down the party he has generously hosted, with the minimum of damage.

He does not want to upset his customers (the markets) too much, as the chaos that can ensue when a crowd of drunks is thrown out onto the street is never pleasant. He needs to gently guide his customers genially to the door.

This in effect is what Fed speak is currently doing. The Fed knows the economy is on a sound footing and that it needs to take some of the financial stimulus away. It is basically saying thanks for your custom, please finish up your drinks and leave the bar. And like any fine host, the Fed pats its drunk customers on the back and promises they will reopen tomorrow so the customer leaves smiling and hopeful.

Time gentleman, please.


Japanese investors are not buying foreign bonds, they’re selling

One of the stories that has driven global financial markets higher for the past few months has been about how Japanese investors are piling, or will pile, into foreign assets. Surely a rational Japanese investor would dump Japanese assets in an attempt to escape the exploding yen and the ravages of domestic inflation, or at the very least seek out a bigger yield than the puny returns available on the artificially suppressed domestic government bonds?

Well, they haven’t been buying foreign bonds; actually they’ve done the opposite. There were lots of headlines earlier this month after Japanese investors were (just about) net purchasers of foreign bonds in the three weeks to May 10th. But data out overnight showed that there were ¥804.4bn worth of net sales of foreign bonds in the week to May 17th, which more than reversed the previous three weeks’ purchases.

The chart below shows the weekly net purchases of foreign bonds, where the data is based on reports from designated major investors including banks, insurance companies, asset management companies etc. The blue line in the chart below is the 3 month moving average, and it shows that Japanese redemptions of foreign bonds are running at close to the highest rate since data began in 2001.

It’s difficult to deduce too much from all the data, but it appears likely that the rally in the Nikkei, the drop in the yen and the rally in semi-core Eurozone government bonds has been down to foreign investors front running something that so far has not actually happened. Japanese investors may still flee their domestic market, but it will require (mostly foreign) investors’ already high inflation expectations to be realised (the bond market is pricing in Japanese inflation averaging +1.8%pa for the next 5 years, despite there being little evidence that QE in Japan or other countries has succeeded in either generating inflation or in weakening currencies). It probably also requires changes to the higher capital charges that major Japanese investors face when investing in overseas assets, although even with this, funding costs and hedging requirements will ensure that home bias continues.

Bondvigilantes Japanese purchases of foreign bonds MR May 13


What is the probability of a U.S. recession in the next 12 months?

Knowing how poor the central banks have been at forecasting economic indicators, and having analysed the IMF’s wild forecasts, we think that it makes sense to take consensus views with a large grain of salt. However, there is a substantial body of empirical evidence that has emerged since the 1980s that suggests that the bond market is a pretty good predictor of real economic activity.

It has been proven that the slope of the yield curve has had a consistent negative relationship with economic activity in the U.S., with a lead time of around 1-1.5 years. By analysing the difference between 10-year and 3-month Treasury rates (also known as the treasury yield-curve spread), it is possible to calculate the probability of a recession in the U.S. in the coming 12 months. The theory goes that a monetary tightening will increase short-term rates, resulting in a flat (or inverted) yield curve as the economy slows and demand for credit falls. Additionally, inflation expectations may also fall at this time.

Research has shown that the yield curve has predicted essentially every U.S. recession since 1950 with only one “false” signal, which preceded the credit crunch and slowdown in production in 1967. This is shown in the chart below. There is also evidence that the predictive relationships exist in other countries, such as Germany and the United Kingdom.

The yield curve is a good recession predictor

Having established the predictive power of the yield curve, economists naturally wanted to assess what the yield curve was telling us about the probability of recession going forward. In 1996, economists from the Federal Reserve Bank of New York estimated the likelihood of recession based on the yield-curve spread.

Helpfully, the Federal Reserve Bank of New York updates its research on a regular basis. So what probability of recession in the next 12 months is the bond market currently pricing in? The answer is 5.38% to be precise (this is probably lower than it should be due to the Fed embarking on a record amount of quantitative easing).

5.38% chance of U.S. recession in the coming 12 months

Some economists swear by the predictive power of the yield curve. Others argue the yield curve has lost some of it predictive power due to other factors that are driving the longer end of the yield curve; such as quantitative easing, currency pegs to the U.S. dollar, and regulations. However, the simple rule of thumb that the difference between ten-year and three-month Treasury rates turns negative in advance of recessions is still reliable, with negative values observed before the 1990-1991, 2001 and 2008 recessions. Perhaps Alan Greenspan’s “conundrum” of low long-term interest rates wasn’t due to what Ben Bernanke termed as a “global savings glut”. Rather, the yield curve was telling us that the chances of recession were rising, and this is reflected in the increase in the probability of recession from 4.5% in January 2006 to 38% in January 2008.

The yield curve remains a great tool for investors. Its power to predict recessions cannot be ignored, so beware if it inverts again.

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The King speech

Today is the last inflation report for Mervyn King, Governor of the Bank of England. He has served the bank for many years and has been the key figure at the bank for the past eight years.

King’s abdication (retirement) is a time to reflect on his achievements at the top. A keen football fan who happily uses soccer analogies, King would probably recognise his time as Governor has been a game of two halves.

The first half was great, with no apparent need to interfere with a perfectly balanced, strong growth, low inflation economy. The second half involved a great deal of stress and the need for intervention as the economy was weak, the inflation target was constantly missed, and he faced the financial equivalent of Chernobyl, as the banking sector began to meltdown.

King is not only a football fan but is also a regular sight at Wimbledon. Rudyard Kipling’s poem ‘If’ is the guide to how players should play on its perfect English grass courts. It is fair to say that King has appropriately treated success and failure in the same way.  I would argue that his failures were in the first half of his term and his strength and ability shone through in the second half of his term. Although his critics may say that the seeds of the financial crisis were sown under his watch.

I think the seeds of the UK financial crisis were as follows:

Inappropriately low interest rates in the USA following the tragic events of September the 11th.

The removal of bank supervision from the Bank of England by Gordon Brown.

The need to hit a rigid inflation target when the world was enjoying low inflation because of world trade and productivity growth meant the use of over stimulative policy, causing a boom to keep inflation on target.

The euro creation resulted in an unstable financial system in Europe.

The first three of these have been resolved with the passage of time, a change in UK banking regulation back to the old ways, and a move around the world to more flexible inflation targeting. The last – the issue of banking in the eurozone – remains unresolved, but there are strong signs that potentially successful attempts are underway to solve the dichotomy of banking support from sovereign states within the eurozone.

We are avid watches of the inflation reports, and will be watching it today. The journalists get to ask questions. If I was there these are the three I would like to ask:

1. What do you think of the euro as an economic concept?

2. How close were we to financial Armageddon?

3. How does QE work?!

Sadly I think Mervyn will be as discreet as always in the press conference. Let’s hope that when he is allowed to speak freely, we get to see a little less candour and more transparency and insight into what has been an exciting time to be at the bank.

I think history will show that Mervyn King did a good job in handling the crisis. After all, that’s what central banks were created to do as lenders of last resort. From an economist’s point of view, what does his leadership prove? Well, Goodhart’s law was again proving itself to be correct. You aim to be a boring central banker and look what happens!


A look at housing affordability in the US and UK

In recent months we have blogged about the recovery in the US housing market that is currently underway. This is in contrast to the UK experience, where the housing market appears to be stuck in the mud. We thought a quick look under the bonnet could reveal the dynamics at play in both countries.

In order to do this, we have constructed a housing affordability index that captures the three main barometers of the health of the housing market; wages, house prices and mortgage rates. By combining average house prices and mortgage rates, we can estimate the typical payments facing a mortgage holder in either country. We have then divided the average wage in both countries by this number. We think that this enables us to get a pretty good read on how affordable housing is in the respective countries.


As the chart shows, owning a house has become considerably more affordable in the US relative to the UK since 2007. There are a number of reasons why this has occurred.

Firstly, US house buyers are feeling rate cuts to a greater extent than their UK counterparts. For example, at the end of 2012 30-year US fixed rate mortgages were 3.35% compared to an average UK fixed rate mortgage of 4.10%. As outlined earlier this month, UK building societies are finding it difficult to pass on any rate cuts because of the impact that such a move would have on their profits. Secondly, wage increases have also favoured potential American homeowners. In the US, wages have risen by nearly 16% compared to an increase of 12% in the UK.

The US has improved on two metrics relative to the UK, but the difference isn’t enough to explain the divergence in affordability between the two markets. The dominant affordability factor has been house prices.

US house prices saw a greater correction, falling by 30% from the peak to trough, while UK prices only fell by 18%. We have now seen US house prices generate solid returns for buyers, with prices now growing at over 10% year-on-year. This is likely to have a significant impact through the multiplier effect on consumption and GDP growth. In contrast, the UK housing market recovered relatively quickly, but since late 2010 house prices have been anaemic.


With the standard variable mortgage rate rising over the last 11 months, limited upward pressure on wages, and stable house prices it appears unlikely that the UK housing market is going to become more affordable for home buyers anytime soon. It is thus understandable that in order to assist potential homeowners, the government has launched its “Help-to-Buy” scheme (following the muted impact of its Funding for Lending scheme) which will come into effect in January next year.

Whether the scheme will work or not will continue to be debated amongst economists. The Help-to-Buy scheme should theoretically impact house prices in a positive way. But this could actually have a negative impact on those looking to buy and potential homeowners may end up borrowing more to purchase a house than they would if the scheme didn’t exist at all.


Pese a las apariencias, los países periféricos de Europa continúan padeciendo una crisis de deuda

This article appeared in English on 26 April.

A comienzos de esta semana, las rentabilidades de la deuda española a 5 y 10 años cayeron hasta los niveles más bajos desde el cuarto trimestre de 2010. No cabe duda de que esta recuperación fue estimulada por los comentarios de Mario Draghi relativos a que el BCE haría « todo lo necesario para salvar el euro» y posteriormente alentada por la mejora de los datos económicos de la zona euro registrada durante el segundo semestre de 2012 la cual, probablemente, se debió en parte a las palabras de Draghi. No obstante, la recuperación de los países periféricos ha continuado durante este año a pesar del importante deterioro que han sufrido los datos económicos en los últimos meses. Actualmente, los fundamentales económicos y las valoraciones avanzan rápidamente en direcciones opuestas.

Lo anterior queda reflejado en el siguiente gráfico: el eje izquierdo representa el diferencial de rentabilidad entre la deuda italiana y alemana a 10 años, y el derecho representa el índice Citi Eurozone Economic Surprise (de forma que si la línea verde asciende implica que los datos económicos son más débiles de lo previsto).

Recuperacion de la deuda soberana de los paises perifericos pese al empeoramiento de los datos

Sigo manteniendo mis dudas respecto a la solvencia de España donde, por insolvencia, me refiero a la situación en la que la ratio de deuda pública sobre el PIB aumenta de forma indefinida. Sí, el BCE puede inyectar liquidez en España para posponer el pago de la deuda y sí, podría decirse que hay muchos otros países desarrollados que se encuentran enla misma situación—la ratio de deuda pública sobre el PIB de Japón se acerca rápidamente al 300%, lo que hace que la deuda pública española parezca relativamente raquítica. Pero como ya hemos visto en el caso de Grecia, la deuda soberana de la zona euro puede ser y será reestructurada si se considera que un país es insolvente y, como ya comentamos anteriormente en una entrada de 2010, parece que  España se dirige hacia tal situación.

Centrándonos en la dinámica de la deuda española a largo plazo, es preciso recordar que la ratio de la deuda pública sobre el PIB de un país cambia en funciónde las siguientes tres variables:

  1. La diferencia entre los costes de financiación de la deuda y el crecimiento nominal como porcentaje del PIB. Si el coste de financiación es mayor que el PIB nominal, aumentará la ratio de deuda pública sobre el PIB.
  2. El cambio en el balance primario de un país como porcentaje del PIB (donde balance primario es el balance presupuestario antes del pago de intereses). Un mayor déficit presupuestario equivale a un aumento de la ratio de deuda pública sobre el PIB.
  3. Variaciones en el ajuste deuda-déficit. Normalmente este ajuste es relativamente pequeño, pero si un gobierno recapitaliza un banco, la ratio de deuda pública sobre el PIB aumenta (más información).

La ratio de la deuda pública sobre el PIB de España se ha disparado como consecuencia de estas tres variables. Analizando a su vez cada una de estas variables, en el siguiente gráfico representa el crecimiento del PIB nominal de España comparado con su coste de financiación nominal a 6 años (en sentido estricto, el dato incluido en la fórmula debería ser el promedio de los costes en concepto de interesesque, en el caso de España, en la actualidad es próximo al 4% —en este caso he utilizado la rentabilidad de la deuda española con vencimiento a 6 años en su lugar). Un coste de financiación del 4% estaba bien entre 2001 y 2007, cuando España aun podía generar un crecimiento del PIB nominal de entre el 7 y el 9%, pero dada la situación actual no es una cifra tan positiva.

Incluso con un menor coste de financiacion, sin crecimiento Espana sigue mostrandose insolvente

Dado que los costes de financiación de España son superiores a su tasa de crecimiento nominal, necesita acumular un superávit primario para poder estabilizar su ratio de deuda pública sobre el PIB (tal como se ha indicado en el punto 2). Pero en la actualidad España presenta un enorme déficit presupuestario (del 10,2% de media desde 2009) y por tanto tiene un enorme déficit primario. En el siguiente gráfico mostramos cómo el FMI ha aumentado de forma constante sus previsiones para el déficit presupuestario español desde 2011.

Los deficits presupuestarios han superado sustancialmente las expectativas

En parte el FMI ha previsto déficits cada vez mayores debido a que sus previsiones de crecimiento han sido excesivamente optimistas. En el siguiente gráfico se muestra como en el 2011 el FMI pensaba que España estaría actualmente creciendo a un ritmo estable del 2%, mientras que la realidad es que se encuentra todavía inmersa en una crisis (recientemente se ha confirmado una tasa de desempleo del 27.2% para el primer trimestre del ano, una cifra récord). La mayoría de las estimaciones de crecimiento a largo plazo elaboradas son simples promedios históricos a la larga, pero dados los elevados niveles de endeudamiento tanto público como privado de España, así como el deterioro de su demografía, la tasa de crecimiento potencial a largo plazo puede ser de tan solo el +1% anual.

El crecimiento de Espana se ha quedado sustancialmente por debajo de las expectativas

¿Y qué sucede con el tercer punto relativo a la ratio deuda/PIB: los ajustes deuda-déficit? Nuestro analista de banca española, Ed Felstead, considera que no es impensable que incluso algunos de los bancos que ya han sido recapitalizados por el estado necesiten serlo nuevamente, a pesar de haber transferido sus activos y préstamos inmobiliarios más tóxicos ala Sareb, el «banco malo» español. Las ratios de préstamos morosos de los bancos ya «saneados» siguen siendo elevadas y la generación de ingresos se mantiene baja debido a la reducción de los márgenes de beneficio. Si se produjera un mayor deterioro de préstamos no-inmobiliarios, los bancos tendrán que hacer mayores provisiones, lo cual generará pérdidas, sin que haya forma de sustituir el capital perdido. Es probable que dicho deterioro se produzca dada la frágil situación de la economía española, junto con el hecho de que las ventas de activos por parte de la Sareb ejercerán presión sobre los precios de los mismos, y la posibilidad de que se introduzca una nueva legislación en materia de ejecuciones hipotecarias y las deudas en mora más favorable para los prestatarios.

Por ello, si no se consigue reanudar el crecimiento en España, los gastos de financiación seguirán superando la tasa de crecimiento, continuarán existiendo grandes déficits presupuestarios y posiblemente veamos la necesidad de realizar nuevas recapitalizaciones bancarias. El FMI ya no prevé una estabilización de los niveles de endeudamiento españoles, al contrario,cree que continuarán aumentando en un futuro próximo, y esto es con unas expectativas de crecimiento del PIB que pueden considerarse todavía algo optimistas. La deuda de los países de la Europa periferica, sobre todo la española, parece todavía vulnerable a sufrir a una venta masiva.

Menor crecimiento y mayor deficit rapido deterioro de la ratio de deuda

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