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Only old central bankers dare tell the truth

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20 th October 2016
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Although not an entirely new phenomenon, the propensity for politicians and central bankers to be much more candid in retirement than ever they were in their old positions seems to be increasing. This has been very true of ex-Bank of England Governor Mervyn King, who appears supinely relaxed about the pound’s recent fall, describing it as a “welcome change” and stating that the reaction to its sharp decline has been “over the top”. He added last week that there were warnings ahead of the vote that Brexit would lead to higher interest rates, lower house prices and a lower exchange rate – which is what the MPC and Bank of England have been trying for years to achieve.

Contrast this with the rather strained tones of the present Governor, Mark Carney, who said last week that the Bank of England is “…not indifferent to the level of sterling” since it has an impact on inflation which is what the MPC/BoE target. On the subject of inflation, he seems to be about to use the perceived adverse impact of the surprise Brexit vote as an excuse to allow inflation to run above its 2% target in coming years. This is exactly what happened in the aftermath of the 2007/08 financial crisis and is only to be expected, as inflation is the sole way to default on government promises that is acceptable to electorates both in the UK and elsewhere. Austerity – a more brutal way of reneging on previous commitments – has already been tried and is a killer of governments.

Mervyn King’s sanguine response to the fate of sterling is perhaps to be expected. He did, after all, preside over the above-mentioned precipitous fall in the value of the pound (even more dramatic than the recent move – so far, at least) back in 2007/08. In contrast, the recent comments of the ECB’s first chief economist, Professor Otmar Issing, were quite shocking. In the eighties and nineties, forex traders hung on to this man’s every word and he became one of the main architects of the Euro Project.

It was therefore quite extraordinary over the weekend to hear the Professor’s deeply disparaging comments on the euro. He warned that the single currency’s days are numbered, saying, “… one day, the house of cards will collapse”. Issing’s main complaint is that the Stability and Growth Pact has not been adhered to, while the many interventions by the ECB have eliminated the need for discipline by the member states. This is doubtless the case but it is equally clear that, without the ECB’s bailouts, the eurozone would have fewer members. Furthermore, in the case of Greece in particular, more was at stake than economics. This remains the case, as Turkey cosies up to a newly opportunistic Russia which, in turn, eyes the ex-Soviet Baltic states.

Bond yields have been on the rise all month throughout Europe, despite the ECB’s ongoing QE programme. The UK, of course, is a special situation and 10-year gilt yields are up almost 40 basis points since the beginning of the month. Elsewhere, the increases in yield are more of a double-edged sword. On the one hand, eurozone economic growth has, of late, been putting in a respectable performance. Despite a recent slowdown, growth is still expected to be 1.6% this year and the EUR’s recent weakness against the USD can only help. Thus, part of the rising bond yield story is a positive reaction to growth and a somewhat weaker currency – at least against the dollar.

On the other hand, it is widely accepted that the financial crisis reduced the eurozone’s productive capacity and, hence, its non-inflationary, trend growth rate. If the trend growth rate was reduced from 2.5% to 2.0%, this puts us very close already to the point at which inflationary pressures will start to build. However, the markets will not wait for much proof. Given the extraordinarily low yields still prevailing in eurozone bond markets, even a whiff of rising inflation will spook investors. With 10-year Bund yields trading at a mere 7 basis points, there is simply no room for nasty surprises on the inflation front.

September’s eurozone final CPI figure was confirmed on Monday as 0.4% on an annualised basis. The ongoing weakness of EUR/USD, coupled with the fact that the decline in the oil price (assuming current levels are maintained) will start falling out of the year-on-year inflation figures from as early as next month, threaten to move eurozone inflation higher with a jolt in the New Year. At major turning points, markets have a habit of ‘tripping’ rather than reversing in a smooth, measured manner. The UK government bond market appears to be at just such a turning point and the markets of the eurozone could be quick to follow.

Perhaps the most exposed European bond market is Italy’s, as we head closer to Matteo Renzi’s reformist referendum on 4 December. Most recent polls have shown the ‘no’ side, who oppose Renzi’s reforms, to be in the lead. If there is anything that has the potential to disturb the uneasy, ultra-low yield equilibrium of the eurozone, it is the ‘wrong’ result in this referendum, leading the way, as it would, to the openly anti-euro, anti-EU, M5S. Indeed, while the world focuses its attention on a contest between two less than edifying US presidential candidates, the bigger event will follow in Italy. If the polls and Professor Issing are correct – and he has not often been wrong – the house of cards will begin to wobble on 5 December. 

All views expressed here are the author’s own and are based on information available at the time of writing.

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