Six months later the biggest economies around the world are still looking for the lost recovery. FXstreet.com is producing the Midyear Check Up of its series What's up, Forex Doc?
UK, Japan, China and US will be reviewed on how they have been done in the last months and what will be the challenges in the middle term. Enjoy!
The Battle of Britain 2012 continues: with the Olympics in sight
The year 2012 has not been easy for any economy, including the British one. The Eurozone crisis has intensified, with many cases unsolved and future uncertain. China, the economic engine of the world in the last 2 years is also showing signs of fatigue. During these turbulent times it is very difficult for the British economy to rebound. GDP has been growing marginally, trading volumes have been collapsing, activity indices have been plunging on top on still declining home prices and months of dampened consumers confidence. All these factors make us wonder what needs to happen in order for the British economy to be back on track. The short-term outlook has changed, but the challenges remain the same. Will the economy recover? What was done and still needs to be done in order for markets to regain confidence? Let us take a view of what is going on in the UK and what can we expect in the months to come.
Quantitative Easing (QE) – more needed?
Quantitative easing has been the most important tool that the BoE has been using recently. The Bank Rate has been set at 0,5% in March of 2009 and has not been changed since then. Chances for an interest hike in the upcoming year are rather low, with the earliest time being Q1 of 2013 although forward rates suggest an even later date. The main tool of monetary policy the BoE has been using for the last three years is the asset purchase program, which began in March of 2009. That is when the MPC gave a green light for the purchase of 200 billion pounds worth of assets, mostly the popular GLITS – UK’s government debt. The bank extended the program by 75 billion pounds in October of 2011 and another 50 billion in February of this year, bringing the total purchases to 325 billion pounds. Now some explanation how does this process works. In January of 2009, the Asset Purchase Facility Fund (APFF), a subsidiary to the Bank of England, was established with the aim of improving liquidity in the corporate credit sector by buying high quality private sector assets. In March of 2009, the Chancellor of Exchequer extended the authority of the MPC to use the APFF to pursue monetary policy goals. The BoE creates money by lending funds to the APF, which in turn purchases the assets (mostly gilts) on the open market. We can see the effects of the asset purchase program looking at the BoE Balance Sheet and how its structure changed since the inception of the program. The loans to the APF are named “other assets” and we can see they constitute the majority of Total Assets of the BoE as of today (picture below).
Assets of BoE, source: Bank of England
On the other side of the equation, the BoE’s loans to the APF have been financed with increased reserve liabilities, which can be seen on the picture below:
The idea behind the program was to help the struggling economy and to prevent inflation of falling to fast (in simple words: boost other asset prices and increase nominal spending). Is the QE doing its job? Or has it been ineffective? Usually in cases like this the QE program is the better evil. It is very hard to evaluate if the injection of funds helped the economy. Investors for sure are happy since there is more cash wandering around. Certainly the situation would have been much worse if that additional money was not created by the Bank. But is this money utilized to boost asset prices, to help the economy? Let’s take a look at the money growth in the economy since the time when the asset purchase program was resumed in October of 2011. According to the most recent BoE’s “Money and Asset Prices” report (part of May’s Inflation Report) “broad money increased by only £19 billion over Q4 and Q1, while the Bank purchased £105 billion of gilts”. We can conclude the money injected by the BoE is not utilized in order to achieve growth. Why is this happening? The Report provides answers, which are worrisome: first it seems the institutions which sold gilts to the BoE retain the proceeds instead of reinvesting them; second, nonresidents’ sterling deposits (which are not treated as money) increased since they bought fewer gilts because of the BoE purchases; and finally, companies which issued bonds used the proceeds to pay off existing debt rather than investing it. It does not mean QE is ineffective, but on the other hand the data shows it is not being utilized properly and measures need to be taken.
An important change was announced by the MPC in February regarding the term structure of the purchased debt. The BoE, in order to diversify risk from concentrating in few maturity sectors, will buy short term debt rather than long term. In more detail (according to the May “money and asset prices” report): “the Bank moved from purchasing gilts equally across three sectors of 3–10 years, 10–25 years
and greater than 25 years, to buying evenly across sectors of 3–7 years, 7–15 years and greater than 15 years”. It is an opposite of what the Fed is doing with its twist operation (sell short term, buy long term debt in order to extend the Fed’s bond portfolio maturity). How all these affect debt market yields?
The asset purchase program along with local interest rates depressed gilt yields to historic lows. We do not expect yields to bounce back any time soon. Not only because we expect the BoE to extend its purchases up to 400 billion pounds, but also because of the weak outlook of the economy (production, output, GDP), which keep real rates at record lows. External factors also have its effect since demand for UK government debt has grown since the European debt crisis is deepening.
In conclusion, the asset purchase program has been in force for 3 years already. Its effects are very difficult to measure but with certainty we can say that if it was not introduced, UK’s economy would have been in a much worse state. Still, much needs to be done. Institutions need to start utilizing the funds they got from the BoE for investments and credit actions. Without it, money will not grow, only the structure of balance sheets changes. Since the global situation has worsened since our last report (mainly because of the European debt crisis), we expect the BoE will extend the asset purchase program by 50-75 billion pounds bringing it to a total 375-400 billion. Additional funds injected along with the Olympics that are about to start very soon could boost the economy in the short term. But the way to recovery is still very long and the first signs of it we should see the earliest in the first half of 2013.
Reputation damaged by LIBOR fixings needs to be restored
An issue that the financial markets in the UK will have to deal in the next couple of months is the LIBOR (London Interbank Offered Rate) fixing scandal in which Barclays, the second largest UK financial institution was involved. The largest investment banks in the world and financial institutions (Citigroup, HSBC, RBS, UBS) are involved in the scandal, but Barclays was the first to admit guilt and was fined a total of 290 million pounds (by the British FSA and U.S Commodity Futures Trading Commission) for manipulating the LIBOR and EURIBOR interest rates. As a reminder, LIBOR is used as a benchmark for setting financial contracts and interest rates around the world (also interest rates on deposits or mortgages) and it is overseen by the British Bankers' Association. Institutions submit rates they expect to pay to borrow from each other for various periods (from overnight to 12 months) and for various currencies (including the majors like euros, dollars, pounds, yens and swiss francs). The banks responses are then averaged to come up with a single LIBOR figure. This model is vulnerable to manipulation downwards, since lower LIBOR rates might project better liquidity measures in the banking sector. The investigation is ongoing but London needs to regain reputation. Following the punishment of Barclays, David Cameron's government has commissioned an independent review of the LIBOR fixing procedures in order to determine its appropriateness and if any legal action will be taken. The review is expected to start soon and finish in September. In order to save the reputation, an independent team of auditors and experts would be the best to perform the review. So far, the government has not announced who will perform it. Nevertheless, the LIBOR scandal is something that London City has to deal with. A struggling economy like the UK cannot afford losing all the cash flowing through London and regaining reputation after the scandal will be one of the main goals of Cameron’s government in the next couple of months.
The labor market
The unemployment rate has been retreating only modestly (by 0.2 percentage points) from an 8.4% multi-yearly high in Q1. The budget cuts that have brought back the recession and prevented a faster rise in employment have been attacked by the opposition, but they are necessary to ensure that the budget gap (projected to reach 7.8% of GDP in 2012) falls to more sustainable levels in the next five years. Otherwise, the rising cost of debt resulting from a loss of confidence of the financial market would create an ominous loop. Europe poses downside risks to the economy, and softness in the all-important trading partner would translate to the UK. The employment rates of the two areas are strongly interlinked, so there might be really no escape from a slowdown in Europe. The upside is that if political leaders get their act together, positive spillover effects from Europe would add to BOE easing and lead to a strong improvement in UK.
UK and Eurozone Employment Rates. The correlation is obvious. Source: ONS, XTB Romania
Tough conditions increase the temptation for protectionism. The Labour Party leader recently said they (LP) “got it wrong” by allowing that much immigration from the New Europe. In 2011 net migration accounted for around a quarter of a million people, while PM Cameron promised to aim to bring that number down to some “tens of thousands”. While reducing the pressure of foreigners on labor markets could prove beneficial in the short term in reducing unemployment it might damage the competitiveness of an economy that relied on outside talent and working stamina to develop after the 1980s (especially in London, the engine for the entire UK economy).
With so much monetary stimulus already in place, or waiting to happen soon, what could prop up the economy further down the road, and then bring consistent relief to the pound? The Olympic Games could provide a boost in the third quarter, but that would probably wane by the 4th quarter. Services stalled and the industry contracted in June the 2nd time in a row, and new orders fell. The austerity program will go ahead, but attaining the deficit target is not going to be easy. While deleveraging eased about 10 percentage points out of household debt (as percentage of gross annual disposable income) UK still has a very long way to go when compared to US, Eurozone or even Spain.
Global deleveraging. Source: Statistics Sweden, Haver Analytics, McKinsey Global Institute
There is also the floated idea of a European banking union, and the pan-European financial tax. While much attention has been focused on the common supervision of banks, there is also momentum behind a financial tax on stock bonds and derivatives trading despite its apparent flop on the June summit. UK is likely to escape both for the time being, but markets would be anxious to read any sign of a bending in front of continental Europe pressures.
The key to the island’s economic future lies not just in Britain, but mostly in Europe and the US. If the European crisis is contained (through massive loss of sovereignty by the South, and a partial German bow to southern demands) or postponed (by ECB or IMF support to the shaking debt markets) UK would benefit from the adjustments, effectively avoiding a deeper drag. On the other hand, should the pace of change not be deemed enough by the markets, the European crisis could quickly escalate to “Lehman-eous” levels, and the financial crisis would only worsen the reluctant economy status. And then there is of course the US, with its slowing engine of growth and “fiscal cliff”. Let’s not forget the debt ceiling and budget cuts dance that would likely keep us (analysts) busy in the months ahead. Some may remember August 2011 and the deep crash that followed US inconclusive talks. Overall the risks point to a rather shaky second half of 2012.
Forecast – what our crystal ball tells us
Given the local macroeconomic picture and the global risk factors, the economy could stall at best, chances being that we would rather witness a decline of 0.2%. Next year would hopefully bring an expansion, but we place our view at 1.2%, below consensus. On the QE front, we expect that bond purchases would add up another 125 billion, taking the total amount to 450 billion, with other programs such as ECTR expanded even further than the minimum 5 billion pounds per auction.
In the reverse beauty contest of choosing the less printed currency, the pound is at odds with the dollar. We suspect that going into the second half of 2012 temptations for the Fed to run the presses will only increase, either through European contagion fighting or austerity sweetening. The next QE round might have been mostly priced in, allowing for a slight appreciation of the pound over the short term. Later in the year a much deteriorated risk environment could push up the dollar, leading to a possible touch of 1.52, or even below that mark.
GBP/USD Weekly Chart, source: XTB Metatrader