Tuesday, 9 March 2010

UK interest rates

The Raven went through the latest version of the BoE inflation report, he's surprised that there isn't more commentary and musings in the media as to why UK inflation is so "sticky" and why unemployment has remaind relatively low during this recession (say compared to what would be expected based on the previous relationship between a fall a GDP and unemployment ie. "Okun's law").

It appears that the BoE is now following the Fed and paying particular attention to "the persistant margin of spare capacity". This fits well with Hugh Hendry's observation that China has continued to expand its export capacity and stockpile commodities during the recession. There is a difference in mandates between the Fed and the BoE, with the BoE much closer to the ECB in just being there to explicitly target inflation, logically the Fed can therefore tolerate more inflation before raising interest rates.

So what has caused this recent surge in UK inflation?
  1. GBP getting beaten with the ugly stick. there is a rough rule of thumb that says that a 10% fall in GBP equates to 1% increase in inflation

  2. It appears that the UK consumer has learnt nothing and continues to bid for housing (houseprices in the UK had ~10% bounce last year after falling only 20%)

  3. Fiscal expansion by the government has created jobs, increased pay deals and generous redundancy terms (ie. 4yrs salary!!)

  4. Exceptionally low interest rates have bailed out most mortgage holders and unlike in the US most UK households are on floating rate schedules, so this monetary policy has very directly put a lot more slack into household budgets than similar moves have been able to do in the US.

  5. Company liquidations have been lower in this recession in the UK (the Raven believes because of 2,3 & 4 above).

  6. Household inflation expectations weren't lowered, purely speculatively the Raven believes this is because commodity prices and food prices were still rising in the first stage of the recession, and we know how much the consumer likes to extrapolate price changes!

We have an 'interesting' event on the horizon in the UK, a general election which could make a massive difference to markets. If the ruling Labour party were to "win" a hung parliament (~40% likelihood according to bookmakers), they have proposed changes to the electoral system in a referendum that would guarantee their participation in future governments, additionally they have indicated that they intend to carry on with their expansion of the state and would run a budget deficit of Greek proportions for the next few years, eventually cutting it back to ~6% by 2012?! Without making too much of a political judgement it should be noted that the government net debt coming into the recession was almost double the level it was coming into the recession of the early 90's. The opposition party on the other hand have made many comments about reducing the deficit and imposing some fiscal restraint and according to the bookies have a 60% chance of winning a majority.

To the Raven its pretty clear where GBP/USD should trade in these two events, Conservative majority ~ 1.80, hung parliament ~ 1.05, Labour victory, well you could at least use £5 notes as toilet paper. Given this a "fair price" would then be 60%*180+40%*105 => 1.50 where we are now, yup those fx monkeys don't do a bad job.

Instead of being glum that the markets looked fair, the Raven looked again at gilts. Regardless of who is to win the next election, they are going to have to run a 13% budget deficit for at least a year or two. Especially when redundancy terms are so stupidly generous for the public sector.

The government borrowed about £200bn last year in the gilt markets, the Bank of England had also been running its QE programme buying about £200bn of gilts, so in reality there had been no net issuance of gilts. Doing a simple regression of net issuance as a % of debt outstanding and looking at the real return on gilts showed a weak relationship for small changes, however for large changes the results were stronger. SO? what would happen with a government of whatever stripes, needing to borrow £400bn over the next two years, but also the BoE having to change from a net buyer to a net seller? well this comes out with a little prediction that 10yr gilt yields would rise to 5.2% by the end of 2010, 6.2% the year after and 7.5% the year after that. Without saying anything about inflation, the output gap, BoE base rates, etc, its pretty clear to the Raven that there is substantial risk in owning 10yr gilts and he's been putting on a small short position that he intends to increase as it goes his way.

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