CENTRAL BANKERS TURN DEAF EAR ON BALANCE SHEET / THE FINANCIAL TIMES MARKETS INSIGHT

May 21, 2013 5:42 pm

Market Insight: Central bankers turn deaf ear on balance sheets

By John Plender

Negative index-linked bond yields point to fear of resurgent inflation

For much of the past two years, markets have been happy to reward profligate sovereign debtors, provided they had their own central banks to hand, ready and able to print money and thus to prevent formal default. The biggest beneficiaries of this largesse were the US and UK.

Among their more obvious attractions were the fact that they were not the eurozone. So despite poor progress on reducing big deficits and debt, the yields on their government bonds fell and their currencies appreciated. That game is now unravelling.

Exhibit one is sterling, which has recently been weakening on (admittedly modest) good news about the economy, including this week’s better than expected inflation numbers. Since earlier in the year, foreigners have been quitting the gilt market and shedding the currency en route.

This is not just a matter of sterling losing its attractions as a safe bolt hole against a eurozone sovereign debt crisis that is in abeyance, though that is part of the story.

The markets are worried at the snail-like progress of chancellor George Osborne’s treasury in reducing the deficit and debt overhang in the absence of more robust growth. Investors have concluded that the UK will retreat from quantitative easing more slowly than the US and that sterling should therefore weaken against the dollar.

So much the better for the UK, you might say. The UK current account deficit is now running at 3.5 per cent of gross domestic product. After years of such deficits, net investment income from abroad is also on a deteriorating trend. Yet in flow of funds terms, the current deficit needs to come down to accommodate a reduction in the fiscal deficit.

As Andrew Smithers of Smithers & Co suggests, you can prove all manner of things about competitiveness in the UK depending on the starting date chosen for sterling. Yet in a recent note, he points out that the real sterling/dollar exchange rate from 1899 to 2012 remained unchanged. As both countries were then on the gold standard at the end of the 19th century, the chances are that the exchange rate would then have been at its equilibrium level.

Yet UK productivity, measured as GDP at constant prices per head of population, has fallen over the period by 30 per cent compared with the US. If, as a wealth of evidence suggests, economies with strong productivity tend to see relative appreciation in their real exchange rates, then sterling is significantly overvalued.

Given the urgent need for the UK to rebalance the economy towards manufacturing, further sterling weakness would be welcome, especially when inflationary pressure is waning.

The US case is different. There the recent rise in Treasury yields has reflected growing speculation that a staged withdrawal from unconventional central banking measures may come sooner than expected. If the dollar is stronger, it is no longer because it is a haven in a financially unstable world but because yield relationships across the world are working more normally.

This is most obviously the case with the yen-dollar rate. Since November 14, when former prime minister Yoshihiko Noda revealed that he would dissolve the Diet, the US-Japan real yield differential after inflation on the five-year government bond rallied by 108 basis points from minus 83bp to plus 25bp. However, the primary driver behind the move in real yields has shifted in recent weeks as US real yields have risen strongly. As with sterling, the more recent exchange rate movement has been as much or more about dollar strength than yen weakness.

The sheer size of the move in US Treasuries is striking. From the beginning of May to the end of last week, yields on the 30-year Treasury bond rose by nearly 40 basis points while the 10-year yield rose around 30bp. That is a measure of the market’s sensitivity to assumptions about an exit from the era of central bank balance sheet expansion. It is also an indication of how far we are from a return to normality.

Yields on fixed interest bonds are still astonishingly low by historic standards and, despite the protestations of central bankers, this is not because inflation expectations are well anchored because of their magnificent management of their currencies. Negative yields across much of the index-linked market tell us that people are desperate for insurance against resurgent inflation.

Meantime, Jaime Caruana, general manager of the Bank for International Settlements, questioned in a lecture in London last week whether unconventional measures had been effective. The exercise in buying time had not, he felt, been accompanied by appropriate balance sheet, fiscal and structural policies. How true. The snag is that central bankers turned a deaf ear to the BIS’s prescient warnings before the crisis and will no doubt do so once again.

Copyright The Financial Times Limited 2013.