After a week of rallies the US stock market fell slightly yesterday. After ignoring generally weak economic data over this period the fall in the Conference Board’s consumer confidence index for July, which fell from a revised 54.3 in June to 50.4 in July appeared to have an impact. In general forward-looking indicators on the US economy have turned downwards recently which in itself does not bode well. One sector which is performing really well at the moment is the banking sector. After the weak stress tests imposed by Europe we saw the bank regulators at Basel suggest that the capital requirements for banks going forward will rise not only by less than expected but also later than expected. If we look at UK banks then Lloyds bank has risen from 53 pence to 72 pence in July and Barclays bank has risen from £2.60 to £3.47. A happy month for bank shareholders.
It is interesting that bank shares have performed well in response to changes in regulation and a weak stress test in the euro zone. In a way this illustrates the nature of their relationship with governments and authority. A move in this relationship affects share prices far more than a change in the economy or business prospects. Those who worry about the nature of this relationship will be concerned by the changes that have come out of Basel. After all relaxing bank regulations worked so well over the last decade did it not? My contention is that whenever pressure looks like it will come on the banking sector then authorities and governments will move to release it.
The UK economy
There have been one or two new trends for the UK over the past week. Firstly economic news has been favourable with economic growth in the second quarter being much stronger than expected at 1.1% followed by a survey suggesting that retail sales have been strong so far in July. In addition our banks have had a share price rally which is good for the UK taxpayer although of course actually selling any of our stakes remains in the distant future. These trends have had one or two interesting impacts.
I have written about UK government bond yields and the way that they have dropped to very low levels. The better economic news has led prices to fall and yields to rise. After nearly touching 3.3% our ten-year government bond yield has reversed to 3.5% which is mainly the result of the economic growth figures.After all if you believe you have growth of 1.1% in a quarter then a yield of 3.3% per year suddenly looks a bit thin to say the least. Also we saw some news from the Bank of England on its Quantitive Easing policy where its gilts holdings ( just under £200 billion) were losing some £1.8 billion as of the 28th February 2010. So right now on a marked to market basis they may well be in profit although this is something of a fantasy as selling such an amount would change the price probably substantially. We arrive at another form of my question of yesterday, what is the endgame?
Another area where there has been some movement has been the UK exchange rate. Against the US dollar we fell to a low on a closing basis of $1.4305 on the 20th May whereas as I type this we are just touching $1.56. Our effective exchange rate (trade-weighted) has risen from 78.175 to 81.422. So one would expect an anti-inflationary impact from this as many commodities are priced in US dollars and hope that the rise in the effective exchange rate does not affect the balance of payments too much. However if one looks further back to the beginning of the year we started at $1.6121 and 79.92. So over this period we have fallen against the US dollar (inflationary) and risen on an effective basis (likely to be bad for the economy particularly if you add in the inflation we have suffered from).
UK Index-linked gilts
These have been suffering from price weakness over the past month or so. One impact on them was the proposed change for many public-sector and some private-sector pensions where the Consumer Price Index will be used in future rather than the (usually higher) Retail Price Index. The significance of this is that index-linked gilts in the UK are priced according to RPI. I think you can see the problem which is investors are asking the question how relevant will these be in the future? As many investors in them are pension funds who are looking to match risks with their inflation liabilities then the differences between the indices (currently 1.9% and averaging 0.55% over the past 20 years) pose a problem and a risk. To give an example our longest dated index linked gilt (1.25% 2055) was at 124.09 on the 18th June (the week before the emergency Budget) and yesterday closed at 119.2. We also have a 0.5% 2050 stock which has fallen from 93.58 to 89.50.
So an unintended consequence of the Coalition governments plans has been that in the short-term it has destabilised the index-linked gilt market. As it is a market which in many respects should be the most stable market as it offers a real rather than a nominal yield we again see the impact of politicians meddling in things they do not understand. As to whether they are good value there are three impacts on them. One is the level of inflation which has been persistently over-target in the UK over the past few years, next is the performance of ordinary gilts and lastly is the level of real yield you feel is sufficient. For example our longest dated “linker” has a real yield of 0.75%.
Spain and her government bond yields
Something rather extraordinary has been going on in the Spanish government bond market recently. After a period where it was under pressure and her benchmark ten-year bond yield looked like it was approaching 5% there has been a turnaround and an improvement. Last night it closed at 4.14%. It was only on the 16th June that it closed at 4.97%. So from the point of view of a sovereign nation Spain can afford a smile for the moment as the crisis has abated for now. Just so that one can see how these matters can really ebb and flow the spread between the ten-year bond yields of Spain and the UK has dropped from +1.43% to +0.63%. Although there is a cautionary note here it was not so long ago (three months I think) that her yields were lower not higher.
Before I analyse the whys and wherefores of this I am reminded of the Spanish bond auction which took place on the 17th June so at the height of the “panic”. Spain issued some ten-year government bonds at a yield of 4.86% and many commentators rushed to call it a success. In truth only time tells you the real answer and as the yield has dropped by 0.72% since then I would suggest it is the buyers rather than the seller (Spain) that had the real success. Spain’s taxpayers will be paying 4.86% for each of the next ten years. Of course there is much that might change over the next 10 years but a month after the auction I know which side of the auction would be happier.
You might think that such an improvement would have been driven by an improvement in Spain’s economic fortunes.
One small good thing is that a small number of cajas will have been forced to reform and recapitalise by the euro zone stress tests as five failed. However the banking sector as a whole has become increasingly reliant on funding from the European Central Bank as interbank markets have become less and less willing to deal with Spanish banks. The most recent report from the Bank of Spain showed Spanish lenders borrowed a record 126.3 billion Euros from the ECB in June which was an increase of 48% from the 85.6 billion Euros borrowed in May. Overall ECB lending dropped by 4% to 496.6 billion Euros to emphasise the divergent issues for Spanish banks. I have written before about the issue of non-performing loans and the debt that Spain is in effect carrying in her private sector that resulted from her property boom turning to bust.
So when we look at Spain as in essence a property boom which has turned to bust what can we see? According to the Bank of Spain house prices continued to fall in June and they are now some 16.5% below the peak which was reached at the end of 2007. Another issue is that unemployment is at a high level and rising being at 19.9% of the workforce. If we look at the other side of that coin employment we get no relief as it fell to 17.66 million in June compared to the recent peak in January 2008 of 19.42 million. None of this is particularly reassuring.
The other Spanish problem is a lack of competitiveness. So we may hope for an improvement from the recent Euro fall (which sadly from this point of view has recently been reversing). However whilst Spanish competitiveness as measured by the ECB’s latest harmonised competitiveness indicator has improved by some 4.7% over the past year this lags both the German improvement of 7.5% and the change in the real exchange rate of 12.1%. In addition Spain’s inflation rate is likely to be affected adversely by the rise in Value Added Tax of 2% which is part of her austerity plan. Her balance of payments deficit was 5.2 billion Euros in April up from 4.4 billion in April 2009 which highlights a continuing competitiveness problem.
It would appear that the recent improvement in the government bond yields of Spain has been driven by perception and subjective views rather than any great sea change in her economic data. Perhaps she is benefitting from her success in the sporting arena. After all she won the football World Cup,Barcelona were in the Champions League final, Raphael Nadal won Wimbledon and Alberto Contador won the Tour de France. Maybe the worlds investors are not as rational as they would like to think. The move has been even more remarkable if you look at the fact that the recent rallies in stock markets have tended to drive government bond yields higher not lower and so Spain’s relative improvement has been even greater.
The Canary in the Coalmine is back
I wrote on this subject back on the 30th March and since then the situation went quiet as least for maturities shorter than thirty-yeras. But as US treasury bond yields have risen over the past week (for example the ten-year government bond yield is 3.05%) we saw yesterday at least for a while the spread for ten-year maturities going negative. One implication of this is that high quality US corporate paper was seen as less risky than paper from the US Treasury. If nothing else it means that economists should stop using US bond yields as an example of a risk-free rate.