UK Austerity and the next Governor of the Bank of England

Today brings into focus an area that has brought good news for the UK over the past couple of years. This has been the improvement in the public finances which rather curiously lagged the period where the economy recorded its fastest economic growth by around 2 years. Also some of the detail along the way has hinted at a better economic situation than that suggested by economic growth measured by Gross Domestic Product or GDP data. This swings both ways in my view as what were called the bond vigilantes will be happier with the state of play. But also those on the other side of the coin who would like more government spending and/or lower taxes would have fiscal room to do so.

Austerity

This has been a matter of debate for some time and let me start by saying there are several ways of looking at this. The harshest would be to actually cut government spending which we have not seen in the UK. Let me add more detail by pointing out that some areas clearly have but overall the story has nor been that as other areas spent more. The more realistic version seems to be restricting government spending in real terms which we have seen some of overall. If we look at it in terms of years then we have recorded on here two main phases firstly from around 2010 when the brakes were applied and from 2012/13 when the pressure on the spending brakes was loosened.

Also there was some tightening on the other side of the fiscal ledger of which the standout was the rise in Value Added Tax or VAT. There was a relatively brief cut from 17.5% to 15% but then a rise to 20% where in spite of the claims of a return to normal it is still at the supposedly emergency rate.

Having established some perspective let us look at this from the IPPR which compared us to these countries “This comprises Austria, Belgium, Denmark, Finland, France, Germany, Italy, Netherlands, Spain and Sweden.”.

We find that on average these countries spend 48.9 per cent of GDP on public spending, compared to just 40.8 per cent in the UK. Furthermore, whilst the UK’s spending has fallen by 7 percentage points – from around 47 per cent of GDP to 40 per cent of GDP – since the onset of austerity, the comparable fall across these countries is just 3 percentage points. Moreover, if the UK were to match their current levels of spending tomorrow it would be worth £2,500 per person per year, of which £1,800 would go towards social spending; meaning health, education and social security.

Okay if we break this down we see that the picture is more complex. Let me show you this by looking at the Euro area in total for 2018 for which we got figures yesterday. There the fiscal deficit was a mere 0.5% of GDP with spending at 46.8% and revenue at 46.3%. Furthermore many of the countries in the IPPR list ran fiscal surpluses in 2018

Germany (+1.7%), the Netherlands (+1.5%), Sweden (both +0.9%), Denmark (+0.5%). Austria (+0.1%).

So on that measure they are more fiscally austere than the UK which ran a deficit. As you can see things are more complex than they argue which is hinted at by the way they use tax revenue as a benchmark rather than total revenues which changes the numbers quite a bit. We have numbers for different periods but my 46.3% for the Euro area is rather different to the 41.1% for their sample and looks a swinging rather than a straight ball to me.

Of course spending is not a free good either. Could we match the spending tomorrow? Yes we could if we wished and for a while with bond yields where they are it would at first be no big deal, but even the IPPR realises it would have to come with this.

But in the UK, as IPPR has previously recommended, significant additional revenue could be raised through increasing the rate of corporation tax in line with the European average, reforming income tax but in a way that protects those on low and middle incomes, and changes to the way in which we tax wealth.

As to Corporation Tax I am dubious as one thing we have learned in the credit crunch era is the way multinationals pretty much choose where they pay tax or if you want the issue in one word, Ireland.

Moving on we see this and again the catch is that in the credit crunch era such Ivory Tower calculations are fine up in the clouds but down here at ground level they have often crumbled.

They find that the cumulative effect of austerity has been to shrink the economy by £100bn today compared to what it would have been without the cuts: that is worth around £3,600 per family in 2019/20 alone.

Today’s Data

The overall picture presented continues to be a strong one.

In the latest full financial year (April 2018 to March 2019), central government received £739.4 billion in income, including £558.6 billion in taxes. This was 5% more than in the previous financial year.

This again hints that the economy has been stronger than the GDP data suggests and follows the labour market theme of rising employment and higher real wages.

On the other side of the ledger the throwing around of the word austerity makes me uncomfortable when we are increasing spending in real terms.

Over the same period, central government spent £741.5 billion, an increase of around 3%.

Well unless you use the RPI as your inflation measure but even then it is roughly flat.

The combination meant this.

Borrowing in the latest full financial year (April 2018 to March 2019) was £24.7 billion, £17.2 billion less than in the previous financial year; the lowest financial year borrowing for 17 years.

Or if you prefer our credit crunch era journey can be put like this.

In the latest full financial year (April 2018 to March 2019), the £24.7 billion (or 1.2% of gross domestic product (GDP)) borrowed by the public sector was less than one-fifth (16.1%) of the amount seen in the FYE March 2010, when borrowing was £153.1 billion (or 9.9% of GDP).

As a single month March was not one for austerity as it looks like departments made sure that they spent their annual budgets so if some potholes were filled in around your locale that is why.

 while total central government expenditure increased by 5.7% (or £3.5 billion) to £65.7 billion.

The explanation is rather bare but if we look at the ledger we see spending on goods and services was up by £1.9 billion. So maybe there was some Brexit stockpiling too.

Comment

The last decade has seen a lot of debate over the concept of austerity involving quite a lot of goalpost moving, so much so that it is fortunate designers give them wheels these days. Whereas we do know what real austerity has been as @fwred made clear yesterday,

Today’s craziest chart goes to Greece, with a primary surplus of 4.4% of GDP in 2018, beating an already insane target of 3.5%. Jaw-dropping for those of us old enough to remember the whole story.

Or as The Nutty Boys put it.

Madness, madness, they call it madness
Madness, madness, they call it madness
I’m about to explain
A-That someone is losing their brain
Hey, madness, madness, I call it gladness, yee-ha-ha-ha

We have seen nothing like that but now face choices ahead as do we copy the Germand and go for a surplus? Or do we now pick out areas where we can spend more? With borrowing so cheap with our ten-year Gilt yield at 1.2% it is not expensive. As ever some care is needed as we have spent in some areas as I note in the IPPR paper than at 7.4% of GDP we spend the same on health as the countries they compare us too which completes something I recall Tony Blair aiming at back in the day.

Meanwhile this has hit the news. I have floated two candidates in Andrew Sentance and Ann Pettifor, but who would you suggest?

Although if Yes Prime Minister has its usual accuracy the choice has already been made and this is just for show

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Public Finance and Retail Sales numbers are upbeat about UK economic prospects

Before we even got to the latest in the current round of UK economic data there has been something of a change in financial markets. So let us reflect this via a tweet from me as I am the only person pointing this out.

Simply extraordinary! The UK ten-year Gilt yield is a mere 1.1% and we can borrow very cheaply. A combination of this week’s £3.4 billion QE from the Bank of England and the US Fed folding last night.

I suppose it is my time in the Gilt Market which means I follow it but there has been quite a shift which is getting ignored. Let me shift to the economic implications of this of which the most obvious is that the UK government can borrow very cheaply. Even if we look at the thirty-year yield at 1.59% it is very low in historical terms and but for the fact we have seen negative yields elsewhere ( and very briefly here) I would call it ultra low. No doubt its move lower last night was influenced by the £3.4 billion of purchases by the Bank of England this week especially the £1.1 billion of our 2057 Gilt. Added to that was the way that as we expected here the US Federal Reserve folded like a deck chair last night as placed a Powell put option under the US stock market.

UK Public Finances

Another area where I have been on a lonely journey is this which I reflected on last week ahead of the Spring Statement in the UK.

 However it does provide an opportunity to make clear how much the UK public finances have improved in the last few years. This often gets ignored in the media maelstrom as the priority is more often to score a political point.

In fact the January figures had been really good but maybe a little too good to be true.

Whilst some tax may have been paid earlier this year and flattered the Income Tax self assessment season the direction of travel is and has been clear.

So let us now find out.

Borrowing (public sector net borrowing excluding public sector banks) in February 2019 was £0.2 billion, £1.0 billion less than in February 2018; this was the lowest February borrowing since 2017.

So that is hopeful as there was no reverse swing but as ever we need to take some perspective for a clearer picture.

Borrowing in the current financial year-to-date (April 2018 to February 2019) (YTD) was £23.1 billion, £18.0 billion less than in the same period last year; the lowest YTD borrowing for 17 years (April 2001 to February 2002).

We see that we have maintained the same trend as the difference between this and January is within the likely error at £500 million. Also the driving force here was as hoped a strong tax collecting season.

combined self-assessed Income Tax receipts were £18.7 billion, of which £14.7 billion was paid in January and £4.0 billion was paid in February; an increase of £1.7 billion compared with the same period in 2018…….Combined Capital Gains Tax receipts were £8.8 billion, of which £6.8 billion was paid in January and £2.0 billion was paid in February; an increase of £1.3 billion compared with the same period in 2018.

I have to confess I am a little surprised at the relative size of the capital gains take and can only think that higher asset prices have helped. Do readers have any insight on it?

This means that looked at in isolation the UK fiscal position now looks very strong and we may be approaching fiscal balance which has been 2/3  years away since about 2012! Of course it may be spent and if we widen our outlook there are plainly plenty of good causes out there such as the Universal Credit shambles and the police for starters.

The national debt position is more complex.

Debt (public sector net debt excluding public sector banks) at the end of February 2019 was £1,785.6 billion (or 82.8% of gross domestic product (GDP)); an increase of £22.7 billion (or a decrease of 1.4 percentage points of GDP) on February 2018.

As you can see the rate of rise has slowed very sharply and such that even the low rate of economic growth we have seen has exceeded it causing the debt to GDP ratio to fall. Now I was asked on here about the banks last week and replied with this.

But it misses out the banks which would add another £283 billion to this. So much less than they did but still there.

So if we put them back in then the debt to GDP ratio is more like 96% but as I then pointed out the poor design of the Bank of England Term Funding Scheme amongst other things means this happens too.

Also they impact in another way as the Bank of England adds £185 billion to the national debt mostly via help to the banks.

So if we knock that off then a more realistic ratio is perhaps 87%.

Retail Sales

These showed yet again that the UK consumer seems to have “spend,spend,spend” on the brain.

The monthly growth rate in the quantity bought in February 2019 increased by 0.4%, with a decline of 1.2% in food stores offset by growth in all other main sectors.

As an aside I have noticed more than a few articles in the media telling us that people are stockpiling food and someone posted a receipt on twitter for over £600 after doing exactly that. But if we move from the media world to the much wide real one we see this.

The monthly fall in food stores was the strongest decline since December 2016 at negative 1.5%, reversing the increase of 0.9% in January 2019, with food retailers suggesting that “getting back to normal” following the January sales had contributed to this fall.

If they stockpiled a few months ago I will only be eating tinned or frozen food at their place.

Moving to the annual picture tells us this.

Year-on-year growth in the quantity bought in February 2019 increased by 4.0%, with growth in all main sectors, while the only sub-sector to show a decline within non-food stores was household goods stores at negative 1.3%.

Those who follow my theme from January 2015 that lower inflation boosts retail sales may like to note that the figures below suggest that at 0.3% it has been at play again.

Both the amount spent and the quantity bought in the retail industry showed strong growth of 4.3% and 4.0% respectively in February 2019 when compared with a year earlier.

If we look at wage growth at over 3% we see that in terms of retail sales we are seeing substantial real wage growth if the official data is any guide.

Comment

We find that the UK economic news continues to be pretty good. There are good signs for consumption from retail sales and the strong public finances do relate to what is strong tax take.

In the current financial YTD (April 2018 to February 2019), central government received £674.9 billion in income, including £512.2 billion in taxes. This was 5% more than in the same period in 2017.

So these numbers suggest we are doing better than we would otherwise have thought and if we also factor in the real wage growth that they might continue. A little caution is required as the money supply data is weak but perhaps GDP growth could continue to bumble on at 0.3% per quarter or so. At the moment if we add in an international perspective that does not look too bad.

Meanwhile some things just cannot be avoided it would seem.

In February 2019, the UK’s GNI and VAT contribution to the European Union (EU) was £2.9 billion, £1.0 billion higher than in February 2018; the highest cash payment in any month on record (monthly records began in January 1993). This is due largely to the timing of payments made to the EU by all member states rather than a reflection of any budgetary increase.

Me on The Investing Channel

 

UK GDP and Public Finances look good but the detail is worrying

Today as is often the case the last full trading day before Christmas brings the latest official data for the UK Public Finances which have had a good year. My main theme today will be to look at the many varieties of statistical manipulation that have been happening or as Marvin Gaye so famously put it.

Oh, what’s going on
What’s going on
Yeah, what’s going on
Ah, what’s going on

We also get as is the new wont a further update on UK GDP which also has a statistical swerve as we note the day has begun badly for France on this front.

In Q3 2018, GDP in volume terms* accelerated slightly: +0.3% after +0.2%.

That is a downwards revision of 0.1% and with the current debate over future public finances there was also this.

In Q3 2018, general government net borrowing increased by 0.4 points: the public deficit stood at 3.1% of the GDP after 2.7%.

The national debt is edging towards 100% of GDP ( 99.3%).

UK Public Finances

On Monday the Office for National Statistics gave us an update on a regular theme on here which is the issue of student loans. This is what the position was.

The UK’s student loan system is based on the government giving loans to most students for their tuition fees and maintenance. Students then repay these loans from their pay packets once they have graduated. Currently, in the National Accounts, these loans are treated as government lending.

That matters because in terms of the deficit lending does not appear. But as I have often argued reality is rather different.

However, the design of the system means much of this student loan debt will never be repaid, and is therefore written off by the government. Because of this, many people, including Parliamentary committees, have asked whether this means some, or all, of the money should be treated as government spending rather than government lending.

So this is what they will do in future.

To ensure our treatment of student loans reflects the way the system works in practice we have decided to split the government’s student loan payments into a portion that is genuine government lending and a portion that is government spending. The lending element will be calculated based on expected future repayments. The remainder, which is not expected to be repaid, will be treated as government spending. This will be treated as capital spending

Fair enough in many ways and as to how much here are the initial estimates.

The Office for Budget Responsibility (OBR) has published some initial estimates for the impact on government deficit. According to these estimates, our new approach will lead to the deficit being increased by approximately 0.6 percentage points of GDP a year, which equates to around £12 billion in the current year.

Of course it is hard not to think of the first rule of OBR Club as we note the numbers ( for newer readers it is that the OBR is always wrong). But as a general direction of travel it looks sound and I welcome it/ The changes should begin in the autumn of next year. In a way it should not matter as reality is unchanged but we do know that changes in measurement do have an impact.

So if we look to the positive we may now see some reform of the failing UK student loan system.

Today’s Data

The news here was good yet again.

Borrowing (public sector net borrowing excluding public sector banks) in November 2018 was £7.2 billion, £0.9 billion less than in November 2017; this was the lowest November borrowing for 14 years (since 2004). Borrowing in the current financial year-to-date (YTD) was £32.8 billion, £13.6 billion less than in the same period in 2017; the lowest year-to-date for 16 years (since 2002).

If we take the broad sweep then revenue growth has been what has made the difference as well as some control over total spending.

In the current financial YTD, central government received £471.1 billion in income, including £353.5 billion in taxes. This was around 4% more than in the same period in 2017.

Over the same period, central government spent £491.9 billion, around 2% more than in the same period in 2017.

Some of this is a reflection of other factors in play as for example the cost of servicing the UK national debt is some £3 billion lower than last year. This is mostly driven by the fall in the annual rate of rise of the Retail Price Index or RPI which defines the UK index-linked Gilt sector.

One area which was a former milch cow is no longer helping as Stamp Duty revenue is £8.8 billion in the financial year so far as opposed to £9.4 billion in 2017.

Moving to the national debt I notice that something we have been looking at has been missed/ignored by financial social media. So here it is and some of you will spot it immediately.

Debt (public sector net debt excluding public sector banks) at the end of November 2018 was £1,795.1 billion (or 83.9% of gross domestic product (GDP)); an increase of £59.3 billion (unchanged at 83.9% of GDP) on November 2017.

Last month the annual increase was only £1.6 billion! The swerve is that the classification change for the UK Housing Associations which was worth circa £65 billion has exited the annual comparison. The numbers do not add up because there have been some genuine changes too.

UK GDP

On the surface nothing has changed and at a time of downwards revisions elsewhere that is good news.

UK gross domestic product (GDP) in volume terms was estimated to have increased by 0.6% between Quarter 2 (Apr to June) 2018 and Quarter 3 (July to Sept) 2018.

Indeed the past was better than we thought at the time.

GDP was estimated to have increased by 1.8% between 2016 and 2017, revised upwards by 0.1 percentage points from the previous estimate.

However the devil is in the detail as when the first estimate of UK GDP for the third quarter of 2018 was released we were told this.

Net trade contributed 0.8 percentage points to GDP growth in Quarter 3 2018, with a 2.7% rise in exports and flat growth in imports.

Whereas now we are told this.

various revisions to net trade estimates led to a widening of the trade balance,

And Boom!

The cumulative effect over this period has been for net trade to have contributed less than previously estimated, most notably in the latest quarter in which net trade is now estimated to have contributed 0.1 percentage points to GDP growth in Quarter 3 2018. This is revised down from 0.8 percentage points and mainly reflects updated estimates of unspecified goods (which contains NMG). ( NMG is Non Monetary Gold)

So there you have it we have a reduction in a component of GDP by 0.7% but  the final answer remains the same. Rather like we have seen at times for Imputed Rent ( when the deflator was changed on a grand scale) and the Diane Coyle critique of the measurement of the telecommunications sector which suggested the numbers were much too low. In each instance we get an acknowledgement and assurances of changes before the Four Tops fire up.

Now it’s the same old song
But with a different meaning
Since you been gone
It’s the same old song.

Comment

Today’s data releases are positive for the UK as headline GDP growth was relatively strong in the third quarter of this year and the public finances continue to improve. There is both a theme and an irony in my next point which it is very cheap for the UK government to borrow right now with the ten-year Gilt yield being a mere 1.29%. The theme is that there is a certain logic with that following better numbers although the major factor is the expected enthusiasm for the Bank of England Whale making further purchases. The irony is that we borrowed a lot when it was much more expensive and borrow much less when it is cheaper.

Meanwhile as I have illustrated today the numbers need to be taken not just with a pinch of salt but the whole cellar.

Let me finish by wishing you all a Merry Christmas although I have not quite finished as I will publish my weekly podcast later. I will be back in the New Year which looks like yet another one of ch-ch-changes before it has even got out of the starting blocks.

Podcast

 

 

 

Was October a sign of the end of austerity for the UK Public Finances?

A feature of the past few months or so is that much of the economic data for the UK has been good, at least for these times. This was repeated by the CBI Industrial Trends Survey yesterday.

Manufacturing output growth picked up in the quarter to November, and firms saw overall order books rebound from a fall in October, according to the latest monthly CBI Industrial Trends Survey.

If we look into the detail we see this.

35% of businesses said the volume of output over the past three months was up, and 17% said it was down, giving a balance of +18%. This was above the historic average (+4%) and a slight pick-up from October (+13%).

So in spite of the ongoing problems for the car sector the manufacturing sector has been growing and above trend. Of course the trend for growth has not been much meaning that over the past few decades it has shrunk as a percentage of our economy but at least it is in a better phase and orders look solid too.

29% of manufacturers reported total order books to be above normal, and 19% said they were below normal, giving a balance of +10%. This was above the long-run average (-13%) and followed a weakening in October (-6%).17% of firms said their export order books were above normal, and 17% said they were below normal, giving a normal balance (0) – above the long-run average of -17%, and marginally higher than October (-4%).

I am not quite sure how to treat the export order books as that implies they were always shrinking, but anyway in relative terms we are doing better than usual. Speaking of exports overall take a look at this I spotted the other day.

Will I have to change the theme of trade deficits that I have run with for over twenty years now? It is way to early to say anything like that because any good month seems quite often to be followed by a reversal. But overall there has been an improving trend in there.

Bank of England

Yesterday several policymakers including Governor Carney were called to give evidence to the Treasury Select Committee. I would like to use the written evidence of Michael Saunders to illustrate their thinking, as it should in my view be questioned much more than it is.

With economic growth having been above potential for six or seven years, the spare capacity created by the recession has now probably been used up.

Hands up anybody who thinks that the past six or seven years have been “above potential”? Also if it has been this is quite a downgrade on the past as whilst I am far from a fan of extrapolating the previous boom we are way below its trends and need to understand why. Whereas the policies that have got us here from the Bank of England have apparently been a triumph. This swerve from central bankers from we saved you to the future is grim does not get challenged anything like enough. I would argue that the many of the problems have been created by their policies.

He is at it again here.

In turn, underlying pay growth (measured by private sector average weekly earnings excluding
bonuses) has picked up from 2-2½% a year ago to about 3% in June-August. This is close to a target consistent
pace, given the subdued trend in productivity growth.

As ever we see a central banker cherry-picking the data to get the answer he wants but let;s be fair. After all with their performances they are unlikely to be keen on bonuses! But there is a suggestion here that 3% wages growth is as good as it gets. Yet the same models which via their output gap theories suggest we can’t grow very fast are the same ones which previously told us that wage growth would be 5% plus if we had an employment situation like we do now.

Also the two statements below need challenging.

Under-employment has fallen markedly over recent years, with the net balance of desired extra working hours now around zero.

Okay so traditional output gap and full employment theory. But how does it go with this?

Overall, a U6-type  underemployment measure (which combines unemployment, IVPTs and the marginally attached) has fallen to 11.8% of the workforce in June-August from 12.6% a year ago.

It seems that there is quite a gap here as we recall that the level we have been guided to for the unemployment rate has dropped from 7% to 4.25% over the past five years, again with much less challenge than should have happened.

Oh and if you are struggling with currency trends Governor Carney provided his thoughts on the matter. From Bloomberg.

“There will be events that move sterling up and events that move sterling down,” he said. “That will likely continue for the next little while.”

The Public Finances

The picture here has been set fair and to some extent that continued today in the official figures.

Borrowing in the current financial year-to-date (YTD) was £26.7 billion: £11.2 billion less than in the same period in 2017; the lowest year-to-date for 13 years (since 2005).

As you can see this picked up the pace on the previous year, and FYE stands for Financial Year Ending.

Borrowing in the FYE March 2018 was £40.1 billion: £5.5 billion less than in FYE March 2017; the lowest financial year for 11 years (since FYE 2007).

So we need to borrow less than we did which means that in relative terms the debt issue is fading as the economy has been growing.

Debt at the end of October 2018 excluding Bank of England (mainly quantitative easing) was £1,598.5 billion (or 75.0% of GDP); a decrease of £33.6 billion (or a decrease of 4.0 percentage points) on October 2017.

Oh and as a technical point it is not mainly QE it is mainly the Term Funding Scheme and if we put the Bank of England back in the ratio is falling more slowly and is 84% of GDP.

The end of austerity?

October itself had an interesting kicker which will be immediately apparent below.

Central government receipts in October 2018 increased by 1.2% compared with October 2017, to £59.9 billion; while total expenditure increased by 7.7% to £65.4 billion.

I have looked into the numbers and if we look just at taxes growth seems to have remained at around 4%. The extremely complicated business as to how we account for interest on the Bank of England’s QE holdings seems to have subtracted about £1 billion which makes up the difference.

Moving to expenditure the explanation is about as clear as mud.

This month, much of the increase in spending was in the current account, with notable growth in both the expenditure on goods and services as well as net social benefits. Over the same period, interest payments on the government’s outstanding debt have increased; due largely to movements in the Retail Prices Index to which index-linked bonds are pegged.

So we spent more because we spent more. As to the index-linked debt we will have to monitor that as overall the numbers are down this financial year and with the oil price now at US $64 that will help.

As ever it is complicated as you see last October we thought we borrowed £8 billion but the figures ( as happens often) have improved.

Borrowing (Public sector net borrowing excluding public sector banks) in October 2018 was £8.8 billion, £1.6 billion more than in October 2017;

Comment

So the overall good economic news has led to a number higher than before for the UK fiscal deficit! It is a reminder that these numbers are erratic as back in July we were noting harsh austerity and now October says “spend,spend,spend.” Whilst there may be some flickers of change in for example the £700 million extra for the troubled local authority sector we need to see more before there is a clear change of direction.

One thing we can be sure of however is the first rule of OBR Club, where OBR stands for the Office of Budget Responsibility. When I checked last October’s it had around half the year’s data but apparently had learnt nothing.

The Office for Budget Responsibility (OBR) forecast that public sector net borrowing (excluding public sector banks) will be £58.3 billion during the financial year ending March 2018, an increase of £12.5 billion on the outturn net borrowing in the financial year ending March 2017.

Up is always the new down for them. Well we should have realised October might be a dodgy month when the OBR released this on the 29th.

On 29 October 2018, the Office for Budget Responsibility (OBR) revised their official forecast of borrowing for the financial year ending (FYE) March 2019 down by £11.6 billion to £25.5 billion.

 

What if Italy slips back into an economic recession?

A feature of bond market and debt crises is not only how far the market falls but how long it lasts. This is because as the majority and sometimes vast majority of debt issued has a coupon ( interest) fixed for its term and so fluctuations in the meantime do not matter for them. The catch is that new deficits need to be financed and existing debt needs to be rolled over and it does matter for them. An example of that is provided by Italy which will issue 2 billion Euros of 5 year bond and 2.5 billion of a ten-year one next week and these will be much more expensive than would have been predicted not so long ago. According to the Italian Treasury or Tesoro some 200 billion Euros of maturities are due next year if we ignored the rolling over of Treasury Bills.

Thus you can see how it takes a while for the costs of a bond market decline to build but build they do. The exact amount varies as for example last Friday we were looking at the nadir for the market so far with a ten-year yield of 3.8% and as I type this it is 3.5%, but both spell trouble. We see regular examples of why this may be bad but let us move to an area where contagion is possible.

The Italian banking system holds €350 billion of government bonds. If 10-year government-bond yields hit 4%, banks’ equity capital will just about equal their nonperforming loans. ( Felix Zulauf in Barrons)

Did anybody mention the Italian banks?

You may not be surprised to read that the ECB press conference yesterday was pretty much a Q&A session on Italy and during it President Draghi told us this.

However we have now the bank lending survey of this quarter. It does say that basically, terms and conditions applied by Italian banks on new loans to enterprises and households for house purchases, tightened. Terms and conditions – so not standards – terms and conditions tightened in the third quarter of 2018, driven by a higher cost of funds and balance sheet constraints.

So things have got tighter for the Italian banks and they have passed it the higher costs to both personal and corporate borrowers. The subject did not go away.

On Italy, I don’t have a crystal ball; I don’t have any idea whether it’s 300 or 400 or whatever. So it’s difficult. But certainly these bonds are in the banks’ portfolios. If they lose value, they are denting into the capital position of the banks; that’s obvious, so that’s what it is.

This was in response to a (poor) question about at what level of the yield spread would the Italian banks hit trouble and the suggestion it might be 400? A better question would be based on Italian yields alone. Also central bankers are hardly likely to tell you a banking crisis is in its way! But you may note that Mario mentioned 3% as opposed to 4% to perhaps cover himself. Also as a former Governor of the Bank of Italy and the Draghi in the Draghi Laws which cover Italian banking his “crystal ball” should be one of the best around.

This brings me to the issue of the Atlante Fund where Italian banks essentially bailed out other Italian banks. We do not seem to get any updates on it now. Can anybody think what might be happening to a portfolio of non-performing Italian bank loans right now? I recall being told that the deals to take such loans were really good value and that my fears were over done. Now I note that the same Unicredit that I called a Zombie bank around 7 years ago on Sky News looks rather like a Zombie bank to me if you look at all the cash piled in since then and the current share price. This whole issue has been a banking crisis in slow motion so let me remind you of the latter parts of my timeline for a banking collapse.

9. Debt costs of the relevant sovereign nation or nations rise.

10. Consequently that nation finds that its credit rating is downgraded.

11. It is announced that due to difficult financial times public spending needs to be trimmed and taxes such as Value Added Tax need to be raised. It is also announced that nobody could possibly have forseen this and that nobody is to blame apart from some irresponsible rumour mongers who are the equivalent of terrorists. A new law is mooted to help stop such financial terrorism from ever happening again.

12. Some members of the press inform us that bank directors were both “able and skilled” and that none of the blame can possibly be put down to them as they get a new highly paid job elsewhere.

13. Former bank directors often leave the new job due to “unforseen difficulties”.

The Budget Plan

If we move on from the “doom loop” that exists between the Italian economy and its banks we get the current fiscal plan which is to run a deficit of 2.4% of GDP ( Gross Domestic Product). Some number-crunching has been undertaken on this by Olivier Blanchard at the Peterson Institute with some intriguing results.

So, take 0.8 percent of GDP to be the relevant measure of expansion………..To give the government the benefit of the doubt, take a multiplier of 1.5. Then, one would expect an increase in output of 1.5 * 0.8 = 1.2 percent on account of the fiscal stimulus.

So we are in the world, or at least what is left of it, of economics 101 where the extra fiscal stimulus will increase GDP by 1.2%. However there is a catch.

Turn to the other half of the story, the increase in interest rates. Since mid-April, Italian bond yields have risen by about 160 basis points……….Recent estimates of the effects of the OMT suggest slightly lower numbers for Italy, in the region of a 0.8 percent output contraction for a 100-basis-point increase in bond rates.

Some of you may have already completed the mathematical implication of this.

Putting fiscal multiplier effects and contractionary interest rate effects together—and being generous about the size of the multiplier and conservative about the effect of the interest rate increase—arithmetic suggests that the total effect on growth will be 0.8 * 1.5 – 0.8 * 1.6 ≈ –0.1. While this number comes with a large uncertainty band, the risks are skewed to the downside.

So via his methodology up is the new down. Or more formally the fiscal expansion seems set to weaken and not boost GDP.

One cautionary note is Olivier’s own record in this area as he was Chief Economist at the IMF when it was involved in the disastrous fiscal experiment in Greece which he sweeps up in this paper as “many politicians and economists argued”. This is of course one of the longest running feature of the credit crunch era as encapsulated by point 12 of my banking crisis time line above.

Comment

The issues above are brought into sharper focus if we note this Mario Draghi and the ECB yesterday.

while somewhat weaker than expected

That rather contradicted the by now usual “broad-based expansion” line which was backed up by some misleading analysis of the monetary situation. The minor swerve was the claim that M3 growth had risen by 0.1% which is true but only because August had been revised lower. The more major omission was the absence of a reference to it being 5.1% last September,

So if we add the expected slow down to the already troubled Italian situation we get a clearer idea of the scale of the problem. If we look back we see that GDP growth has been on a quarterly basis 0.3% and then 0.2% so far this year and the Monthly Economic Report tells us this.

The leading indicator is going down slightly suggesting a moderate pace for the next months.

They mean moderate for Italy.So we could easily see 0% growth or even a contraction looking ahead as opposed some of the latest rhetoric suggesting 3%  per year is possible. Perhaps they meant in the next decade as you see that would be an improvement.

 

 

Much better UK public borrowing gives the Chancellor an extra Budget option

Sometime we find ourselves with the opportunity to look at things from a different perspective and learn from it and this morning is providing that. Let me illustrate with this tweet from @SunChartist.

Are 4.5 year high in Italian bond & 52 week high on Spanish bonds yields bullish Euro? Asking for a friend.

It did not need to draw my attention to the Italian bond market which has been falling again and set new lows for this phase today. In futures terms its BTP December contract is a bit over 118 which means the ten-year yield has reached 3.8%. I forget which investment bank said that between 3,5% and 4% was the point of no return. That is over dramatic in my opinion, but it is what Taylor Swift would call a sign of “trouble,trouble,trouble”.

There is now a hint of contagion as we note that the Spanish bond market is falling today and its equivalent yield is now 1.8%. Context is needed as it is less than half the Italian equivalent and rises were always likely as the ECB scaled back its purchases under its QE programme but a change none the less. However and this is my main opening thrust today there is a small or medium-sized island depending on your perspective which has seen its bonds doing well over the last week or so. It is the UK where the ten-year Gilt yield has fallen from above 1.71% to 1.53%. Again memes can be overdone but looked at in isolation there is a case for suggesting there has perhaps been what is called a flight to quality or a move towards a safe haven. Of course safer haven would be a better description for a market once described as being on a “bed of nitroglycerine” but however you spin it UK Gilts have been in demand.

I have looked at it this way because this week the media have been looking at it in a different way as this from the Financial Times highlights.

Even if Mr Hammond sticks to his current target of balancing the government’s books by the mid 2020s, government debt will fall only slowly as a proportion of GDP, because the long-term outlook for growth is so lacklustre.

Actually this misses out that the national debt to GDP ratio is falling which has been demonstrated by this morning’s official release.

Debt (Public sector net debt excluding public sector banks) at the end of September 2018 was £1,789.5 billion (or 84.3% of gross domestic product (GDP)); an increase of £3.4 billion (or a decrease of 2.4 percentage points) on September 2017.

As you can see we are seeing a fall and economic growth is lacklustre as the recent rally is not yet in the figures. In essence the outlook for the public finances is always poor if you have a weak economy. Anyone who did not know that has been taught it by the experience of Italy.

If we move onto the other parts of the FT quote there is the reference to the ongoing fantasy that the government has some plan to actually balance the books. Personally I think it has been surprised by the recent better figures as it was continuing the past philosophy of George Osborne where a balanced budget was perpetually 3/4 years away.

So in fact something which is being spun as unlikely is if we look at the facts above quite possible especially as we note that the UK Gilt market has not only ignore such reports it has rallied.

“Increasing borrowing is clearly the line of least resistance,” said Paul Johnson, the IFS’ director, noting that Conservative chancellors have historically been more likely to announce giveaways when the public finances were better than expected, than to raise taxes when finances were worse than expected.

Still there is something refreshing which is the acknowledgement of this, and the emphasis is mine.

debt could rise as a share of national income over the longer term, because periodic recessions would hit the public finances.

I do hope that this is not a one-off and that the IFS will continue on this road as I am reminded of a bit in the film Snatch which explains the economic consequences.

All bets are off!

Today’s Data

We had another month of improved figures.

Borrowing (Public sector net borrowing excluding public sector banks) in September 2018 was £4.1 billion, £0.8 billion less than in September 2017; this was the lowest September borrowing for 11 years (since 2007).

This meant that the deeper perspective continues to look good as well.

Borrowing in the current financial year-to-date (YTD) was £19.9 billion: £10.7 billion less than in the same period in 2017; the lowest year-to-date for 16 years (since 2002).

This was due to the fact that tax receipts are solid and spending increases have been below the rate of inflation.

In the current financial YTD, central government received £352.4 billion in income, including £265.6 billion in taxes. This was around 4% more than in the same period in 2017.

Over the same period, central government spent £368.0 billion, around 2% more than in the same period in 2017.

If we look into the detail we see that VAT receipts are strong being up £4.4 billion at £74.7 billion. Also Income Tax is doing well as it is up £5.8 billion at £81 billion in the tax year so far. Given the state of the UK housing market you will not be surprised to see that Stamp Duty receipts have fallen by £0.5 billion to £6.5 billion.

On the other side of the coin you could argue that the fall in spending is flattered by lower debt costs of £3.1 billion as the impact of past inflation rises washes out of index-linked Gilts to some extent.

Comment

As you can see the UK Gilt market has been on the opposite path to the rhetoric of the mainstream media and those presented by them as authorities. One way of looking at this is to consider the phrase “put your money where you mouth is”. But it is also true that markets are not always right which has been highlighted this year best by those who bought Italian bonds at a negative yield. That is not going to be so easy at the next investors conference “Wait, you actually paid to hold Italian bonds?”. It is also perhaps revealing to note that the media seems to have taken Paul Simon’s advice about the Gilt market rally.

No one dared
Disturb the sound of silence

It is, however also wrong to say it is plain sailing as whilst we have entered a better phase it could quickly change if the economy stopped ignoring the weakness in the monetary data. Actually some of the tax receipt data above hints the economy may have done better than we have been told. So on that note let me leave you with the words of Avril Lavigne.

Why’d you have to go and make things so complicated?
I see the way you’re
Actin’ like you’re somebody else, gets me frustrated

Higher bond yields and higher inflation mean higher national debt costs

The last week or so has brought a theme of this blog back to life and reminds me of the many years I spent working in bond markets. They have spent much of the credit crunch era being an economic version of the dog that did not bark. Much of that has been due to the enormous scale of the QE ( Quantitative Easing) sovereign bond buying policies of many of the major central banks. The politicians who came up with the idea of making central banks independent and then staffing them with people who were anything but should be warmly toasted by their successors. The successors would never have got away with a policy which has benefited them enormously in terms of ability to spend because of lower debt costs.

Italy

However the times are now a-changing and this morning has brought more bad news on this front from Italy. The BTP bond future for December has fallen to 120 which means it has lost a bit over 7 points over the last ten or eleven days. Putting that into yield terms it means that the ten-year yield has reached 3.5% which has a degree of symbolism. A factor in this is described by the Financial Times.

The commission issued its warning to the Five Star and League governing coalition after Rome deviated from the EU’s fiscal rules by proposing a budget deficit equivalent to 2.4 per cent of gross domestic product instead of the 1.6 per cent previously mooted by the finance minister Giovanni Tria. Although the new plans keep Italy under the EU’s 3 per cent deficit threshold, the country’s high debt levels — the highest in the eurozone after Greece — means Rome is required to cut spending to bring debt levels gradually lower.

However the chart below tells us that in fact you can look at it from another point of view entirely.

Actually I think that the situation is more pronounced than that as the ECB has bought 356 billion Euros worth. But you get the idea. It is hard not to think that a major factor in the recent falls is the halving of ECB QE purchases since the beginning of this month and to worry about their end in the New Year. In case you were wondering why the share prices of Italian banks have been tumbling again recently? The fact they have been buying in size in 2018 when one of the trades of 2018 has been to sell Italian bonds gives quite a clue.

If we switch to the consequences for debt costs then a rough rule of thumb is to multiply the 3.5% by the national debt to GDP ratio of 1.33 which gives us 4.65%. In practice this takes time as there is a large stock of debt and the impact from new debt takes time. For example Italy issued 2 billion Euros of its ten-year on the 28th of last month at 2.9%. So a fair bit less than now although much more expensive that it had got used too. This below from the Italian Treasury forecasts gives an idea of how the higher yields impact over time.

The redemptions in 2018 are approximately €184 billion (excluding BOTs) including approximately
€3 billion in relation to the international programme……..the average life of the stock of
government securities, which was 6.9 years at the end of 2017.

Oh and the tipping point below has been reached. From the Wall Street Journal.

Harvinder Sian, a bond strategist at Citigroup, thinks a 10-year yield of 3.5%-4% is now the tipping point, after which yields jump toward the 7% reached at the height of the last euro crisis

Personally I am not so sure about tipping point as the “gentlemen of the spread” ( with apologies to female bond traders) have been selling it at quite a rate anyway.

 

The United States

Here bond yields have been rising recently and let us take the advice of President Trump and look at what has happened during his term of office. Whilst back then Newsweek was busy congratulating Madame President Hilary Clinton my attention was elsewhere.

There has been a clear market adjustment to this which is that the 30 year ( long bond) yield has risen by 0.12% to 2.75%.

We see that it has risen in the Trump era to 3.4% although maybe not by as much as might have been expected. However if we look to shorter maturities we see a much stronger impact.For example the two-year now yields some 2.9% and the five-year some 3.07%. So if you read about flat yield curves this is what is meant although it is not (yet) literally true as there is a 0.5% difference. Thus the US now faces a yield of circa 3% or so looking ahead. This does have an impact as the New York Times has pointed out.

The federal government could soon pay more in interest on its debt than it spends on the military, Medicaid or children’s programs.

In terms of numbers this is what they think.

Within a decade, more than $900 billion in interest payments will be due annually, easily outpacing spending on myriad other programs. Already the fastest-growing major government expense, the cost of interest is on track to hit $390 billion next year, nearly 50 percent more than in 2017, according to the Congressional Budget Office.

If we switch to the Congressional Budget Office it breaks down some of the influences at play here.From its September report.

Outlays for net interest on the public debt increased by $62 billion (or 20 percent), partly because of a higher rate of inflation.

The CBO points out a factor the New York Times missed which is that countries with index-linked debt are also hit by higher inflation. As the US has some US $1.38 trillion of these it is a considerable factor.

Also the US is borrowing more.

The federal budget deficit was $782 billion in fiscal year 2018, the Congressional Budget Office estimates,
$116 billion more than the shortfall recorded in fiscal year 2017………The 2018 deficit equaled an estimated 3.9 percent of gross domestic product (GDP), up from 3.5 percent in
2017. (If not for the timing shifts, the 2018 deficit would have equaled 4.1 percent of GDP.)

Higher bond yields combined with higher fiscal deficits mean more worries about this factor.

At 78 percent of gross domestic product (GDP), federal
debt held by the public is now at its highest level since
shortly after World War II. If current laws generally
remained unchanged, the Congressional Budget Office
projects, growing budget deficits would boost that
debt sharply over the next 30 years; it would approach
100 percent of GDP by the end of the next decade and
152 percent by 2048 . That amount would
be the highest in the nation’s history by far.

I counsel a lot of caution with this as 2048 will have all sorts of things we cannot think of right now. But the debt is heading higher in the period we can reasonably project and I note the CBO is omitting the debt held by the US Federal Reserve so that QE would make the figures look better but the current QT makes it look worse.

Comment

Debt costs and the associated concept of the mythical bond vigilantes have been in a QE driven hibernation but they seem to be showing signs of waking up. If we look at today’s two examples we see different roads to the destination. If we look at the road to Rome we see that the longer-term factor has been the lost decades involving a lack of economic growth. This has made it vulnerable to rising bond yields and which means that the straw currently breaking the camel’s back has been what is a very small fiscal shift. It is also a case of bad timing as it has taken place as the ECB departs the bond purchases scene.

The US is different in that it has a much better economic growth trajectory but has a President who has also primed the fiscal pumps. Should it grow strongly then the Donald will win “bigly” as he will no doubt let us know. However should economic growth weaken or the long overdue recession appear then the debt metrics will slip away quite quickly. That is a road to QE4.

Returning back home I note that UK Gilt yields are higher with the ten-year passing 1.7% last week for the first time for a few years.So the collar is a little tighter.The main impact on the UK came from the rise in inflation in 2017 leading to higher index-linked debt costs. This was the main factor in our annual debt costs rising by around £10 billion between 2015/16 and 2017/18.