Interest rates and the economy
Steve Williams, Cormorant Capital Strategies
The bond market has a tremendous impact on the real economy.
It affects the return we enjoy on savings and the rate we must pay for credit. It influences our potential for employment and earnings by controlling the cost of capital for businesses. Our taxes might be higher or lower, depending on the bond market’s assessment of our government’s ability to repay the capital it borrows. In the final analysis, the bond market has the power to bring down governments.
While central banks can, with relative ease, affect interest rates at the near-term horizon through what we know popularly as the ‘base rate’, it is much more difficult to sustain desired changes in longer-term rates. The outlook for the economy, and consequent inflation expectations, is the dominant influence on longer-term rates.
And while a less gloomy outlook for the economy might encourage higher rates, the relationship between the two operates in a sort of ‘feedback loop’. Higher rates might, in turn, damage the outlook for the economy.
In the US, for example, a resurgent housing market has contributed much to a nascent recovery. But the potential for further rapid gains in housing activity is eroded as house-purchasers’ borrowing costs track higher.
The average 30-year mortgage rate, according to Freddie Mac, stands close to a two-year high at 4.6%. The average for the 15-year term is 3.6%. Coinciding with rising borrowing costs is a fall of 17% in applications for purchase loans.
It seems unlikely that the rise in rates that we have seen thus far is enough, on its own, to derail a global recovery. But there is certainly a limit to how far rates can go up before they have detrimental impact on growth.
MPC votes to keep base rate and QE
The Bank of England’s Monetary Policy Committee (MPC) has voted unanimously to keep base rate at a record-low 0.5% and the BoE’s programme of quantitative easing (QE) at £375 billion.
None of the committee members thought it appropriate to firm monetary policy, as none of the knockout conditions that would invalidate its new policy of forward guidance were breached. In August, the BoE said it would keep base rate at 0.5% until the unemployment rate falls below 7%, or unless inflation spikes, suggesting the base rate will rise at some point in 2016. The BoE is also prepared to add to QE while the unemployment rate remains above its desired level.
However, Mark Carney added that the MPC will have to consider rate changes if inflation is expected to go beyond 0.5% of its target in 18-24 months or if there are any threats to financial stability. The minutes also say more QE may be warranted if the recent economic recovery stalls. “Were the recovery to falter, the case for further asset purchases would be stronger. But no member judged that further stimulus was appropriate at present.”
Earlier in September, statistics from the Office for National Statistics showed the number of people unemployed in the UK fell below 2.5 million to 7.7% in the three months to July. However, this is still some way above the 7% “knockout” suggested by the BoE. Inflation eased in August, making a base rate rise even more remote at this time. Inflation fell 0.1% to 2.7% in August.
Base rate has been static since March 2009, when the MPC first voted to cut rates to record-lows in a bid to help stimulate the economy. On the same day the MPC launched its programme of QE, which was increased by £50 billion to £375 billion in July 2012, though the committee has voted in factions since then with some members, including former governor Mervyn King, backing a further increase to the programme.
Are the emerging markets in retreat?
Steve Williams, Cormorant Capital Strategies
In April 2013, the International Monetary Fund (IMF) warned of a three-speed recovery for the world economy. It said the recovery would be characterised by significant strength in the emerging markets, a middling expansion in the US and a flatline in Europe.
Since then, the FTSE All-World Developed Index has outperformed the FTSE All-World Emerging Index by around 15%. The worst affected stock markets – namely those in Brazil and India – have lost around 25% in US dollar terms. Over the same period, the Indian rupee has lost 15% and fallen to an all-time-low against the US dollar.
A number of factors might explain the sell-off in emerging market currencies and assets, but the coinciding rises in longer-term interest rates are arguably the most compelling. Brazil and Indonesia have made it clear that their troubles have risen with the likelihood that the Federal Reserve will taper its bond purchases.
Beginning in May, the yield on the ten-year US government bond climbed from 1.6% to a current level of almost 3%. Government bond yields have all tracked US yields higher in the UK, Germany, France, Australia and even Japan, where government efforts are focused on keeping rates low.
So, the IMF’s next economic outlook will be a bit of an about-face, and have a very different view of the sources of global growth to those of the past. But the IMF was right on the money when it warned that the end of a relaxed monetary policy in the West might provoke financial market turmoil in the East.
The West’s central banks are still perhaps years away from actually tightening monetary policy. Following any tapering, the US bond-buying programme will remain significant and Japan is only just beginning its own large-scale asset purchases. International investors are taking their money out of the emerging market nations as quickly and as thoroughly as they can.
There are many reasons why rising bond yields in the West might encourage capital withdrawal from developing nations. Higher rates from safe US, UK or German government bonds are becoming more attractive to those who have been denied income by earlier falls and have anxiously held onto risky emerging market assets. Then there are the ever-more appealing investment opportunities that come with an improving economy at home. But, whatever the cause, the consequences of rising bond yields are greater for some developing countries than for others.
Within the ‘BRICS’ nations (Brazil, Russia, India, China and South Africa), it is India that has most cause for anxiety. Key to its hopes for a sustained recovery is a raft of infrastructure projects. These will be increasingly difficult to sustain as dollar-priced oil and raw materials cost the impoverished Indian government more and more.
India’s tumbling currency has sent the rate at which the government can borrow over a ten-year period to over 8.5%. In nominal terms, India has the world’s largest fiscal and current account deficit, so its policymakers do not have a great deal of room for manoeuvre. They’ll do well to avoid a sustained and increasingly damaging rout in the market for rupees.
Markets sceptical about forward guidance
The Bank of England’s (BoE’s) forward guidance on interest rates is not convincing the markets.
Forward guidance said that, subject to three defined ‘kick-outs’, the BoE expected to review the base rate only when the UK unemployment rate reached 7%, which its forecasts suggested would not be until the second half of 2016. However, the current unemployment rate is 7.7%.
The ensuing welter of ‘Three years of low interest rates’ headlines seems to have convinced the general public. The latest quarterly BoE inflation attitudes survey shows that only 29% of those asked expect rates to rise in the next year, the lowest response since November 2008 and the fourth lowest since the survey started in 1999.
The markets, however, are still unconvinced. They are betting on base rates starting to climb sometime around the end of next year. The yield on the five-year benchmark gilt has been steadily rising since the BoE’s announcement in early August. Part of the problem is that the BoE’s announcement has been overtaken by events.
Economic news has generally been upbeat since forward guidance emerged. UK GDP growth in Q2 was revised up to 0.7% and the Eurozone – the UK’s most important export market – came out of recession in the same quarter with growth of 0.3%. The OECD is forecasting 1.6% growth for the UK in the second half of the year and many other forecasters have lifted their GDP projections. A variety of surveys support this view, because the construction, services and manufacturing sectors are all reporting strong growth. Even the Chancellor has taken the risk of saying that there were ‘early signs’ of growth, if not the green shoots of recovery.
There are also doubts about the kick-out that would apply if CPI inflation is “more likely than not” to be 2.5% or more in 18-24 months’ time. The BoE doesn’t have the best track record on inflation forecasting – 2% in two years’ time has long been its favoured incantation. But its most recent inflation bulletin put the probability of 2.5% of more inflation two years’ hence at over 40%. That appears to leave little leeway for error.
The BoE has responded to the markets’ doubts in several ways. Governor Mark Carney gave a speech in Nottingham, for example, in which he argued the case for the 2016 target. He felt the market had not allowed for the growth in productivity and the move from ‘involuntary’ part-time to full-time employment when considering the 7% unemployment target. He also emphasised the importance of public and business perception of future interest rates over that of the markets.
The BoE could find itself in a difficult position next year if the economy continues to recover. The latest 0.1% fall in the unemployment rate underlines the risk.