Today sees further economic updates which will tell us a little more about the state of the UK economy. These are the British Retail Consortiums (BRC) update on retail sales in February and the balance of payments figures for January 2010. Taking the retail sales figures first we saw the following according to the BRC. UK retail sales values rose 2.2% on a like-for-like basis from February 2009, when sales had dropped 1.8%, hit by snow and consumer caution. On a total basis, sales rose 4.5% against only 0.1% growth in February 2009. So in comparison with a poor February in 2009 we did a little better and if anything it adds to the data indicating a weak recovery in the UK.
Trade Figures
I am particularly interested in the trade figures because there has been some hope of improvement because of the depreciation in the UK exchange rate. Now it is not the fall over the last month that concerns me because it will take time to have an impact but more the depreciation that took place in 2007/08. Using the monthly average for the Bank of England’s effective (trade-weighted) exchange rate then we had a peak of 105.45 in January 2007 and which then fell over time to 76.64 in March 2009 giving us a fall of 27.3%. As you can see there was a substantial fall and economic theory would indicate that an improvement in the UK trade balance should result. Also in case you are wondering this fall was followed by a small rally in our exchange rate but our effective exchange rate is 77.03 as of Monday nights close.
J Curve
The reason for the delay is called the J curve in economics. What this means is that a country’s trade deficit will worsen initially after the depreciation of its currency because higher prices on foreign imports will be greater than the reduced volume of imports. However as time goes by this will be replaced by a longer and hopefully more permanent effect where the effects of the change in the price of exports compared to imports will eventually induce an expansion of exports and a cut in imports–which, in turn, will improve the balance of payments.
Other Effects and imported inflation
An even longer term effect is where a country benefits from the J curve but where the depreciation causes an increase in prices and then inflation which is often called “imported inflation”. This is a particular concern for the UK over this period as we have fallen heavily against the US dollar over this period and so many commodities and raw materials are priced in US dollars.So these commodities will be relatively more expensive. Accordingly for a depreciation to be successful in the long-term the country has to have a low inflation rate and specifically keep its inflation at the rate or better still lower than its trading partners.
This is the bad part for the UK because our inflation rate is higher than that of our trading partners. Japan is mired in disinflation where her prices are falling, Europe’s last Consumer Price Index measure was at 1.0% and ours is at 3.5%. So we are in danger of eroding the competitive advantage that we gained from our depreciation particularly as it is not clear how far our inflation will rise and for how long. By comparison many European economists feel that Euro zone inflation will fall back towards zero this year.
Policy Mistake
This is one of the reasons why I felt that Quantitative Easing (QE) was a mistake you see this expansionary monetary programme began in March 2009 just as our depreciation was hitting its peak and just as one would expect the favourable economic results of it to be felt and to build up. Looking at it in this way and remembering that interest rates had been reduced from over 5% to 0.5% as well as fiscal policy being expanded with measures such as the temporary cut in Value Added Tax then it is no surprise at all that inflation has picked up although sadly it does appear to have come as a surprise to our economic policy-makers.
If the inflationary impacts of QE prove to be longer-term then this highly expensive programme may come to actually harm the UK’s economic prospects over the next decade and this is ignoring the problems and issues around reversing it. This would be a damning indictment of the policy.
The Numbers
If you compare 2008 with 2009 then we did see some improvement . The UK’s deficit on trade in goods and services fell from £38.2 billion in 2008 to £33.8 billion in 2009. However this is not as good as one might have hoped even trying to allow for the effect of the credit crunch on exports in the finance sector (where we are strong or perhaps one might now say over-represented!).
If we look at today’s numbers for January 2010 then they too are disappointing with the UK’s seasonally adjusted deficit on trade in goods and services being £3.8 billion as opposed to the deficit of £2.6 billion in December 2009. Our seasonally adjusted deficit in just goods rose from £7 billion to £8 billion. Now of all the numbers I look at trade figure estimates are probably the most unreliable and I still cannot believe the time when markets waited for them with bated breath. However sadly the ones we have a telling the same story that appears to come form 2008 and 2009 that we have gained very little from the currency depreciation of 2007 to early 2009. Perhaps the worst aspect of January’s trade figures are the fact that the increase in the deficit was mostly caused by a fall in exports. You see the main exporting nations around the world seem to be seeing an increase in exports so we can no longer blame world circumstances.
Conclusion
Whilst trade figures are unreliable particularly on a month on month basis ours have disappointed throughout the period of the credit crunch. I have been following them with a little more interest than usual because just after the Pre-Budget Report last year the Office of National Statistics published an update which included favourable revisions for the first part of 2009 which at the time looked like they might be the beginning of an improvement (to give you an idea of the scale it looked like it was possible if that trend continued that our trade deficit for 2009 might be of the order of £20 billion rather than the£33.8 billion it turned out to be if it continued). However this has simply not taken place as data for the second half of 2009 and January 2010 have arrived.
These numbers have implications for growth in early 2010 as well as posing a question mark against any economic recovery in the UK as we appear even with a favourable exchange rate movement to be unable to do much about our persistent Balance of Payments problems. Indeed with the policy error of QE it is possible that by letting inflation into our system we may in the medium term be in danger of making it worse via imported inflation.
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“If the inflationary impacts of QE prove to be longer-term then this highly expensive programme may come to actually harm the UK’s economic prospects over the next decade and this is ignoring the problems and issues around reversing it. This would be a damning indictment of the policy.” It will prove to be entirely that. You do not seem to acknowledge the fact that this gambit was entirely a political action – not one for economic good! There was never any intention (as with all previous political printing of Monopoly money) to “reverse” or redeem this debt in the proper Keynesian manner as the economy recovered.
“However sadly the ones we have a telling the same story that appears to come form 2008 and 2009 that we have gained very little from the currency depreciation of 2007 to early 2009. Perhaps the worst aspect of January’s trade figures are the fact that the increase in the deficit was mostly caused by a fall in exports. You see the main exporting nations around the world seem to be seeing an increase in exports so we can no longer blame world circumstances.” As one with much experience and knowledge in these things, I have already explained why this is so, in one of my previous comments. The myth that weak Sterling will produce an export boom in the present scenario is totally ill-founded, and is spread by those who do not understand the realities and the true interdependencies. The numbers show this truth, but the politicians want to continue the myth. Why should anyone who understands be surprised?
Hello I am doing some research on Gold and the Euro and came across your blog. For my finance class we have to choose a investment based on the Greece crisis. My plan was to go long Gold and short the Euro but I am having a hard time understanding why the EURO was going down during the past few months. I understand that investors in Europe would buy gold as a safety measure from Greece. Basically I’m a little confused why the EURO went so much lower when we first heard about the Greece crisis. From my understanding the commission cannot print any more Euro’s. Also what do you think about being long gold and short Euro as an investment. I know that it might be a little late to enter the trade but I still think gold has another big leg up. I would love to hear your thoughts and of this. Thanks
Hi Bubs
To answer your question about why the Euro fell then there were several factors. If you analysed the performance of the Euro over the credit crunch then before the Greek crisis the Euro had been strong. I can particularly vouch for this against the £ as I have taken holidays in Italy recently and each time the exchange rate has deteriorated (1.50.1.25,1.10)!. Against the US $ it had risen because of the perceived impact of the credit crunch on America. However the Greek election which revealed the misrepresentation of her economic figures meant that Greece came under pressure and the reasons why posed questions for Spain, Portugal, Italy and Ireland. It became clear that the level of the Euro was too high for these countries economic competitiveness. So the Euro suddenly did not look quite as good a buy and it fell.
As to your trade if you feel that the Greek crisis will continue then being short the Euro is wise. However by buying gold you have an instrument that may disappoint you. This is because presumeably you will buy the dollar to sell the Euro and the US dollar often moves into the opposite direction to gold. In the current situation it is difficult to say where the next crisis will arise. If you take my logic you might sell the Euro and buy the Dollar but if problems erupt in America you may not thank me!
As to the gold price there is a lot of good news in it my old tutor at the LSE thinks it is a 6000 year bubble! So perhaps it is due a drop in the short term but all such forecasts are very difficult. Also time periods matter here as day to day week to week or even month to month are difficult to forecast.
If you want my view I suspect that the US $ will be perceived as a safe haven and will rally if we look at say this year (to end 2010). Remember too that markets do not move in a straight line as there are ebbs and flows. Oh and good luck!
Thanks a lot for the detailed response I really appreciate it.
I understand your stance on the gold U.S. dollar relationship as that is mentioned as a risk in my investment. My belief is that if the dollar rises the Euro will fall and gold will be flat to only slightly lower. I know history has proven me wrong but this is also the first real test for the Euro in its history. I think that the only reason for the dollar rise is a drop in the Euro. Honestly both currencies look awful but unfortunately one of them has to go up. I’m playing this out as a pair trade and believe that the combination of being long gold and short Euro will be profitable.
I will also be buying some out of the money calls on the dollar as protection for the risks mentioned above. It would be much easier to just buy gold in Euro terms but my assignment requires me to play ETF’s in the U.S. If you go to http://www.goldprice.org/spot-gold.html you can see the prices of gold in various currencies. Against the Euro gold is still almost at all time highs. This shows that the recent run up in the U.S. dollar this year has had no effect on gold priced in Euro’s. My play is that this trend will continue.
Not sure how familiar you are with the U.S market but looking at your profile I have a feeling I’m talking to a expert. Here is the trade in details.
Buy $100,00 worth of GLD (Gold ETF)
Short $100,000 worth of FXE (Euro ETF)
Buy slightly out of the money calls on the UUP (Dollar ETF)
Im still working on how I’m going to play the calls and how much money to put toward it. I plan on the U.S dollar hedge being very minimal and just there for protection in case the U.S. dollar skyrockets. My feeling is that if the U.S. dollar skyrockets the Euro will come crashing down and gold will fall.
Not trying to convince you of anything just letting you know what I am thinking. Thanks again for the knowledge on the Euro and your thoughts of the trade. Will definitely be a daily reader of the blog and hopefully we can have future discussions.
Bubs