Euroland "basic balance" deterioration suggesting weaker euro

Posted on Thursday, May 10, 2018 at 10:50AM by Registered CommenterSimon Ward | CommentsPost a Comment

Euro appreciation in 2017 was underpinned by a strengthening of the Euroland basic balance of payments position. The basic balance has deteriorated recently and credit / money trends suggest further weakness. Downside risk for the currency, therefore, has increased.

The “monetarist” approach to assessing currency prospects assumes that:

1) major currency swings are caused by changes in the basic balance, defined as the sum of the current account and net direct and portfolio capital flows; and

2) movements in the basic balance are caused by changes in the differential between the expansion of domestic bank credit and the growth rate of money and other domestic bank liabilities.

On 1), the first chart below shows the Bank of England’s euro effective exchange rate together with the Euroland basic balance, calculated on a six-month rolling basis. A positive relationship is apparent, with the basic balance sometimes leading currency swings. Euro strength in 2017 was associated with a turnaround in the basic balance from a large deficit into surplus. This improvement partially reversed in late 2017 / early 2018. The euro’s recent decline may reflect this reversal.

On 2), the basic balance mirrors – by accounting definition – changes in the net external assets of the banking system (including the monetary authority). This is because a basic balance surplus or deficit necessitates an offsetting flow of funds through the banks.

The change in banks’ net external assets, meanwhile, is equal to – again by accounting definition – the difference between their new domestic funding (i.e. money and other liabilities, including capital and reserves) and domestic credit expansion. A surplus of domestic funding relative to lending, for example, is reflected in a flow of funds overseas and a rise in net external assets.

The second chart shows the gap between domestic credit and funding flows of “monetary financial institutions” (MFIs) and the basic balance, plotted inverted. The correspondence is not exact because the definitions of the series do not precisely correspond to theory and because of measurement error.

The monetarist approach assumes that this relationship is causal, i.e. changes in the balance between domestic credit and funding flows determine changes in the basic balance, which in turn drive currency movements.

The monetarist approach was the basis for a suggestion here in January 2017 that the euro (as well as the yen and renminbi) would rise against the US dollar in 2017. The thinking was that the ECB’s wind-down of QE would curb domestic credit expansion, while stronger economic growth would boost the demand to hold money and other bank liabilities. A narrowing of the gap between domestic credit expansion and domestic funding growth would strengthen the basic balance and boost the euro.

This scenario played out, with six-month rates of increase of domestic credit and domestic liabilities converging in August / September 2017 – third chart.

A follow-up post in December, however, suggested that the balance between domestic credit and funding flows would turn negative for the euro in 2018, reflecting the ECB’s tardiness in normalising monetary policy. The slow pace of QE wind-down coupled with a likely firming of private lending growth would limit a further decline in domestic credit expansion, while the refusal to adjust policy rates to reflect a stronger economy and 1-2% inflation was likely to depress demand for bank liabilities.

Recent trends are consistent with this forecast, with growth of domestic liabilities falling with credit expansion little changed, and the basic balance moving back into deficit. The assessment of the December post still appears valid, with a possibility that the ECB will delay ending QE and push back a rate rise even further in response to recent softer activity data, a fall in core consumer price inflation and renewed concern about Italian political and economic instability.

The monetarist approach, by contrast, suggests a positive outlook for the US dollar, with the Fed’s QE reversal plans implying an increasing drag on domestic credit expansion and money demand likely to be boosted by rising interest rates.

UK monetary trends: weakness extends

Posted on Tuesday, May 1, 2018 at 02:36PM by Registered CommenterSimon Ward | CommentsPost a Comment

Before Bank of England Governor Mark Carney’s latest handbrake turn, the expectation here was that the MPC would raise interest rates again in May, based on prior “guidance” and strong labour market data. Such a move, however, was viewed as dangerous against a backdrop of weakening monetary trends.

The change of signal from Governor Carney, of course, had nothing to do with monetary concerns. It seems, instead, to have been part of a loosely coordinated shift in favour of slower policy “normalisation” by major central banks, excluding the Fed, probably motivated by a combination of US dollar weakness and softer economic data. The Bank of Canada also pushed back against early rate hike expectations, while last week’s ECB and BoJ communications were dovish.

The MPC shift has slightly reduced downside economic risks but March monetary data released today continue to suggest deteriorating prospects.

The forecasting approach here emphasises the narrow non-financial M1 measure, comprising cash and sterling sight deposits of households and private non-financial corporations (PNFCs). Annual growth of this measure fell further to 4.4% in March, the lowest since 2012, while the rate of increase in the latest three months was just 1.6% – see first chart.

Broad money trends are also weak. Annual growth of non-financial M4 – which includes household / PNFC holdings of sterling time deposits, cash ISAs, short-term bank securities and repos – declined to 3.4% in March, with a 2.4% rate of increase in the latest three months. The comparable figures for the Bank of England’s M4ex broad measure were 3.8% and 1.2% respectively. M4ex includes financial-sector money holdings but these are volatile and contain little information about near-term economic prospects.

The second chart shows the two-quarter change in GDP and six-month changes in real non-financial M1 and non-financial M4, i.e. deflated by consumer prices (seasonally adjusted). The recent decline in inflation has supported real money trends but the six-month changes remain close to zero, suggesting very weak economic prospects.

The slowdown in real non-financial M1 was initially driven mainly by the household component but the six-month change in corporate (PNFC) real M1 fell to zero in March – third chart. This is significant because the corporate component individually has been a reliable leading indicator of GDP trends – it turned down well in advance of the 2008-09 recession – and current weakness may indicate that business are cutting back investment and expansion plans.

In a recent speech, the MPC’s Michael Saunders downplayed concern about weaker broad money growth, arguing that households’ demand for money has been depressed by a portfolio shift into mutual funds. Without presenting data, Mr Saunders suggested that, adjusting for this shift, broad money growth was similar to the last few years.

The fourth chart compares annual growth of non-financial M1, non-financial M4 and a broader measure incorporating national savings, foreign currency deposits and retail flows into UK-registered unit trusts and OEICs (“non-financial M4++”). Growth of this latter measure is, indeed, around its average in recent years.

Mr Saunders’ view that this resilience offers reassurance about economic prospects is not shared here, however, for several reasons.

Mutual fund holdings are not money. A portfolio shift out of money into funds indicates a reduced likelihood of near-term spending. Focusing on an all-encompassing aggregate, therefore, risks throwing away important information about economic prospects.

Consistent with this, the broader measure has underperformed non-financial M1 and non-financial M4 as a forecasting indicator in recent years. Annual growth of nominal GDP rose over 2012-14, fell in 2014-15, moved up again in 2015-16 before declining recently. Each of these swings was clearly signalled in advance by the conventional money measures. Growth of the broader aggregate, by contrast, showed  little variation. In particular, it failed to predict the recent significant nominal GDP slowdown.

While annual growth of the broader aggregate remains respectable, its six-month change is now weakening. Together with the rise in consumer price inflation since early 2016, this has resulted in a meaningful fall in six-month real growth – fifth chart*. The broader financial aggregate, that is, is belatedly confirming the slowdown signal from conventional money measures.

*Latest = February; mutual fund flow data for March have yet to be released.

Global leading indicators confirming monetary slowdown signal

Posted on Friday, April 27, 2018 at 02:31PM by Registered CommenterSimon Ward | CommentsPost a Comment

The monetary forecast of a global economic slowdown over the remainder of 2018 is receiving confirmation from shorter-term non-monetary leading indicators.

A March update of the widely-monitored OECD composite leading indicators is scheduled for release on 14 May. Most of the component data, however, are already available, allowing an independent calculation.

The first chart below shows the G7 normalised indicator together with the independently-calculated series, which includes a March estimate and incorporates revisions. The series levelled off in January / February and fell in March. The normalised indicator is designed to signal turning points in the level of output relative to trend, i.e. the March decline suggests future below-trend expansion

The recent reversal in the indicator has been driven by Japan and Europe, with the US component still rising – second chart.

Available evidence suggests that global (i.e. G7 plus E7) six-month industrial output growth reached a seven-year high in March – third chart. Previous posts suggested that a peak would be reached around March, based on a peak in six-month real narrow money growth in June 2017 – the average lead time at turning points historically has been nine months. The chart shows six- and one-month rates of change of a trend-restored G7 plus E7 leading indicator derived from the OECD data. Six-month growth peaked most recently in November 2017; the average historical lead time has been four months, so this is also consistent with a fall in six-month output growth after March. With one-month growth of the indicator still weakening, a further fall in the six-month increase is likely.

The OECD composite leading indicators incorporate a mixture of soft data (business and consumer surveys), hard series (e.g. housing starts / permits, manufacturing new orders, auto registrations / output, average / overtime hours, the ratio of manufacturing inventories to sales) and financial market indicators (e.g. the slope of the yield curve, stock prices). Of the G7 plus E7 countries, only the indicators for Canada and India include a monetary aggregate (M1). The indicators, therefore, provide an independent, though less timely, cross-check of monetary signals.

Is the global economy facing "slowflation"?

Posted on Wednesday, April 25, 2018 at 11:31AM by Registered CommenterSimon Ward | CommentsPost a Comment

Previous posts expressed concern that a global economic slowdown during 2018 would be accompanied by a rise in inflationary pressures, constraining central banks’ ability to provide policy support for weakening markets. Recent inflation news provides some support for this view.

G7 headline and core (i.e. ex. food and energy) consumer price inflation rose in March, with the core rate reaching the top of its post-GFC range, matching highs in 2012 and 2016 – see first chart.

The recent core rise has been driven by the US and Japan. The US increase partly reflects the dropping-out of last year’s large cut in mobile data charges. In addition, shelter inflation, which was also a drag in 2017, recovered to a seven-month high in March – shelter has a 41% weight in the core basket and is dominated by actual and imputed rents.

Upward pressure on rents is suggested by the low level of the rental vacancy rate, which fell in the fourth quarter of 2017, with a first-quarter figure to be released tomorrow – second chart.

Shelter inflation has also displayed a lagged relationship historically with house price inflation, which has continued to pick up – third chart.

Our start-of-year commentary suggested that Chinese monetary policy would be eased during the first half of 2018, a development that “could give a further short-term boost to commodity prices, which would add to global inflation concerns”. Evidence continues to build of a policy reversal, with newswires yesterday reporting that an “informed source” expects a further cut in banks’ reserve requirement ratios, following last week’s surprise reduction.

The fourth chart below shows the gap between G7 headline and core inflation along with the annual rate of change of the S&P GSCI commodity price index, with this rate of change projected forward assuming that the GSCI is stable at its current level. The relationship implies a widening of the gap near term, in turn suggesting that headline inflation will move above its February 2017 high, assuming stable core inflation.

Business surveys and equity analysts’ earnings revisions are consistent with a peak in economic growth – fifth chart – but consumer confidence measures remain elevated, giving rise to hopes that a slowdown will be modest and temporary. Higher inflation could contribute to a decline in consumer optimism.

UK inflation numbers have surprised on the downside in the last two releases but, as elsewhere, recent commodity price strength may lift the headline rate near term – sixth chart. As previously discussed, annual unit wage cost growth may have moved up to about 2.75% in the first quarter, while producer output price trends suggest a near-term reacceleration of core consumer prices – seventh chart.

Will Chinese policy easing work?

Posted on Thursday, April 19, 2018 at 12:20PM by Registered CommenterSimon Ward | CommentsPost a Comment

Satisfactory Chinese activity numbers for the first quarter / March are consistent with monetary trends in mid-2017. Subsequent monetary weakness, which continued in March, suggests a significant slowdown over the remainder of 2018. The authorities appear to be shifting tack to head off economic weakness. Late cycle policy easing can prove counter-productive by boosting prices, thereby exerting additional downward pressure on real money trends.

This week’s activity numbers were mostly solid, although annual industrial output growth fell to a seven-month low in March as an upward distortion from the late timing of the Chinese New Year unwound (discussed in a previous post).

Two-quarter growth of nominal GDP, seasonally adjusted, rose slightly further last quarter, consistent with a stabilisation / small recovery in six-month narrow money expansion in mid-2017 – see first chart.

Narrow money trends, however, weakened sharply after September, with six-month growth falling further in March to its lowest since January 2015, suggesting a significant loss of economic momentum alongside weaker inflationary pressures through late 2018.

Credit trends are also concerning: the percentage increase in the stock of “total social financing” in the first quarter, of 3.2%, was the lowest on record in data extending back to 2004.

The authorities, therefore, appear to be moving to ease policy. A fall in term interbank rates in early April suggested that a shift was under way and this week’s reduction in the reserve requirement ratio for a range of banks, involving a net increase in liquidity supply, offers confirmation.

Market perceptions of a Chinese policy turnaround may have driven this month’s recovery in risk assets and contributed to renewed strength in commodity prices.

As previously discussed, Chinese loosening, together with a recovery in US narrow money growth in lagged response to tax cuts, could result in a revival in the global real money growth measure tracked here. Late cycle policy easing, however, can be ineffective or even counter-productive, feeding directly into higher prices without boosting nominal money trends.

The US FOMC was not, as is sometimes claimed, asleep at the wheel in the run-up to the 2008-09 recession – it cut the fed funds target rate by 100 basis points between August and December 2007, with the US recession beginning in January 2008, according to the NBER. Policy easing, however, contributed to a surge in commodity prices that continued into mid-2008. This surge fed through into global consumer prices and, with nominal money trends remaining weak, was an important reason for the six-month change in real narrow money turning negative – second chart.