Friday saw the UK receive an update (second estimate) on her Gross Domestic Output figures for the fourth quarter of 2009. However as I stated in my article on Friday whilst the figure for this particular quarter rose from 0.1% to 0.3% according to the Office of National Statistics there were also revisions to past data and so I concluded that in fact we were pretty much back where we had started before the update came out. In fact having had time over the weekend to read the numbers again our fall during the recession was revised down by 0.25% so in stock terms (total output as measured by GDP) we were actually slightly worse off than we had previously thought although we were coming out of recession at a slightly faster rate than we had previously thought. I wanted to make this clear today in precise terms as I feel that these figures have been misrepresented in many places by those who only read the headline figures.
UK Government Bonds
There is more and more debate on this subject and how we can finance our borrowings. As I have written for some time we have faced a deteriorating situation since November 2009 when we compare the yield on our government bonds with Germany’s (Germany is used as an international benchmark). At the ten-year maturity where international comparisons are usually made the spread has risen from +0.37% on November 2nd 2009 to over +1% recently (as measured by Reuters). As of Friday’s close the spread had improved slightly to +0.93% .
Now many commentators have focused on whether the UK will lose its AAA credit rating for long-term debt. Also government politicians have mentioned that we are in no danger of losing this status. However their writings and speeches are irrelevant for two reasons.
1. Because of the change in yields for our government bonds we are being treated by the markets as if we have already lost this rating. To put this into figures in terms of our European peers then both France and Germany have a AAA credit rating. Their ten-year government bond yields on Friday closed at 3.42% and 3.10% whereas the UK equivalent closed at 4.03%. So the market has already made its decision.
I hope that you are sitting comfortably because there is worse news to come. Italy is graded four notches below us in the arcane world of international credit ratings but her ten-year bonds yield 3.97%. So in effect we are being treated as if we have already lost four notches off our credit rating.
2. Ratings agencies invariably act ex post rather than ex ante. If you study their behaviour they invariably confirm what has already happened rather than being a forecast of what is about to happen. If you also thing about this it is a clear failure in their function as their ratings are used by many as a guide to the future. I have written many times about the failings of ratings agencies and my disappointment that they have not be reformed or closed down. But this is probably their most fundamental failing. To quote the advert they do not do what they say on the tin.
Taking these points further we are in fact now in danger of losing our official credit rating because our government bond market is in effect on the way to making up the credit rating agencies minds. A week or two ago when I wrote about our government bond yields nearly touching 4.3% we must have been in danger of a downgrade. Perhaps the finger was on the trigger we will have to wait and see. Markets ebb and flow and our rise in bond yields was never likely to be a straight line particularly when the biggest holder of UK government bonds hints that he may buy some more! If the Bank of England was going to do so then it is quite possible this will be announced at 12 o’clock on Thursday at the end of the Monetary Policy Committee meeting.
Three good things
Whilst our recent economic history has been rather profligate it was not always so. Our government debt has been well-managed in the past so that our average maturity is 14 years whereas a country often considered something of a paragon Germany only has an average maturity of 6 years. So we have to roll over less debt from our existing stock which means that rise in interest rates will affect our existing stock of debt more slowly. We may well be grateful for this in 2010 and 2011.
We have currency flexibility and can depreciate/devalue (although this can be a poisoned chalice as described below).
The size of our national debt at around 60% of GDP compares internationally much better than our current fiscal deficit so if we can reduce the deficit then our position will look much better.
The UK £ exchange rate
During the early part of 2010 the £ exchange rate has come under pressure. For example 3 months ago we were around 1.65 against the dollar and we now around 1.51 and 3 months ago we could receive around 150 yen per £ whereas today the exchange rate is 135.4. Against the Euro we have in fact been much more stable, another way of putting this is that the problems in the Euro zone have affected us too.
Most of this fall has taken place quite recently. If we look at the effective exchange rate where the Bank of England looks at all exchange rates and our international trade to calculate a trade weighted index then we have fallen from 81.66 on the 27th January to 77.92 on Friday’s close. So not only have our bond yields been on a rising trend our exchange rate has been falling. In these figures is a guide to what the rest of the world thinks of us.
What does this mean?
1. Hopefully our exports will be more competitive and we will export more. However a cautionary note is required here because we had a fall in our exchange rate in 2007/08 and our exporters appeared to use this to increase their profits as much as they used it too increase volume.
2. This is not good for inflation as imported commodities will be more expensive. Here the US $ is very important not only because we do a fair amount of trade with America but also because many commodities and raw materials are priced in US $. For example oil,metals, foods and many others. So the fall will import some inflation. The danger of this is that if we let the inflation become permanent then it will erode and possibly eliminate the gains described in the first point above.
One of the reasons why I have been against policy measures such as Quantitative Easing is exactly the effects I have described above. I was afraid that inflation might erode the competitive advantage we received form our devaluation in 2007/08. I felt that many commentators were complacent and failed to realise how powerful a depreciation can be if used properly. Instead as our recent rising inflation figures have shown we are eroding the gain and if our Monetary Policy Committee remains as complacent as it has been then maybe we will lose the lot.
I have also noticed many other economic commentators coming round to the view that inflation may now be a problem. This for them is quite a volte face as they were usually predicting disinflation (negative inflation) if you look at their forecasts. My fear is that this is too late and as an aside it would be nice if they included an element of mea culpa rather than ignoring or sadly in some cases rewriting their past. It brings my profession into disrepute I feel. They are in danger of merely telling us what has happened rather than looking forwards (for example the real issue is now how we deal with the uptick in inflation which is combined with a weak recovery) and leaves them looking as useful as the ratings agencies.
Market Update 1:05pm
Having written this article I notice that the fall in the sterling exchange rate has accelerated today and that we are currently at $1.49 which is down 2.72 cents on the day and we are now at 1.10 versus the Euro. So at this time quite a substantial fall and also the trade has been very volatile so I will let it settle and return to this subject tomorrow if new analysis is required.
Also has the Prudential hedged its planned big take-over of AIG in the Far East today? This may have shook things in the currency markets.