Yesterday saw the UK £ exchange rate come under severe pressure and heavy selling. This morning we seem to be remaining at the new lower levels with the exchange rate being 1.491 versus the US $, 1.1043 versus the Euro and 132.41 versus the Yen. When I started to write my article of yesterday we were at 1.51 versus the US $ and 135.4 versus the Yen so it was a sharp drop. On the day there were two likely causes of this. One is the narrowing of the opinion poll lead of the Conservative opposition which raised the prospect of a hung parliament and the other was the announcement (and possible hedging of a £15 billion currency risk) of the Prudential’s bid for AIA which is AIG’s operation in the Far East.
Again as I wrote yesterday this is a trend which against the US dollar and the Yen has been in place for some time. What was added to it yesterday was a fall against the Euro. This is significant because due to the crisis in Greece and other so-called Club-Med countries the Euro has been under pressure itself. In my view there are deeper factors influencing what is happening than just a one day market panic.
First is that the recent bad figures for public finances have made many international investors take a harder look at our public finances. The January figures which showed a deficit in what is usually a tax collecting month were concerning. However it looks as though these figures have raised questions about underlying issues. The last decade has seen a growing reliance by the UK on various off-balance sheet accounting tricks such as the Private Finance Initiative (PFI). Those who come to London and travel on the Tube may find references to this and its problems hard to avoid! A more comprehensive look at the UK finances will remind investors that our public-sector pensions are unfunded. They may conclude that the risks are starting to look not so dissimilar to Greece. It is not impossible for them to conclude that there are risks that an incoming administration might need to “review” overall debt levels from issues such as PFI just like what has happened in Greece.
The current government in the UK chose to enact what is called a pro-cyclical fiscal policy. What this means is that they not only expanded the public-sector in an economic boom from around 2002 they expanded its share in the economy as measured by comparing the size of the public-sector with Gross Domestic Product. Events have now proved that this has turned out to be a mistake in itself. Also this was a failure of philosophy because the Chancellor at the time who is now Prime Minister got financial market support by establishing a “Golden Rule” where national debt was not supposed to exceed 40% of GDP. Sadly for this rule currently this ratio is at 60% and rising quite fast due to the size of our fiscal deficit which could easily be 13% this year. In other words as soon as the rule required some fiscal discipline it was abandoned. Put yourself in the shoes of an international investor and ask yourself what would you conclude from that when you think of the fiscal credibility of our government?
There is a further issue which relates to our banking sector, and thank you to my ex- tutor at the London School of Economics for reminding me of this point. If you take a hard look at the UK finances as international investors now are they see something which differentiates the UK from others. This is that bank balance sheet liabilities are around 400% of GDP which makes us look exposed and vulnerable. This has been reflected in the size of the bank bail outs required particularly with Lloyds Bank and Royal Bank of Scotland. However these banks also have foreign currency liabilities and looking at the size of the UK banking sector it would be very hard for the Bank of England to be able to bail these out.
What happened yesterday?
The effect of the changing opinion polls and maybe some selling of the £ to finance the Prudential’s large bid was combined with the deeper issues highlighted above. I try as far as is possible to avoid politics in my articles but I am willing to offer an opinion on our political class.
Perhaps the most important issue facing us is our fiscal deficit as it will determine many other things such as the economy, NHS etc. Now which of our maun political parties has a clear plan to deal with it that they have explained and itemised? Probably the best is Vince Cable but neither of the two main parties have a clear plan and the Liberals are very unlikely to win.
One of the ironies of the public spending splurge that happened in the UK from 2002 was that there was little scope for fiscal stimulation when the credit crunch hit. Our response to the crisis was around 2% of GDP which was at the lower end of international responses. So the pro-cyclical policy pursued from 2002 hindered the contra-cyclical policy which should have been pursued (if we could have afforded it …) with more vigour from 2007/08. It also meant that our authorities (who realised but did not publicise this) indulged in a massive monetary stimulus which involved the hapless Quantitative Easing project. From one mistake many unintended consequences can flow.
Government Bond Market Reaction
Our yields rose yesterday with our ten-year yield rising to 4.1%. With the German ten-year bund closing at 3.1% then the spread is easy to calculate at +1%. I notice that Spain was in the news yesterday and coming under criticism, however it is revealing I think that her comparison with Germany is at +0.82%. In other words international markets feel that our situation is 0.18% worse!
The effect of a currency fall on a bond market is more complicated than you may think. A foreign investor holding a sterling bond will have lost money yesterday,but a foreign investor considering buying will see them as cheaper as his/her currency will buy more. Some existing investors may have chosen to hedge the exchange risk. So it is not simple but cutting to the chase the main influence is what they feel will happen next because why buy now if you feel the pound is going to fall allowing you to buy more cheaply.
There is a corollary of this which I think of when I hear politicians criticising “speculators”. As I have described above there are many investors following many objectives at one time in any reasonable market. Which one is the investor and which is the speculator? Now some may have what are considered to be bad objectives, but in recent years money has usually been made by attacking what have been political failings. This is what I feel really upsets the politicians! A real inconvenient truth perhaps.
As a personal view I find it hard to see our government bond yields doing anything but rising over the next few months. Unless we relapse into a severe double-dip/depression scenario our combination of slow growth and persistent inflation is not good for a bond holder.