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Saturday 15th October 2016
Hi Friend,
All eyes on Sterling ... how low can it go?
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Sterling closed at $1.22 against the dollar this week.
Why is Sterling falling? That's easy! More sellers than buyers the simple answer. Cause of death - stopped breathing, the autopsy report. More detail required. So here goes. Sterling is in play. With futures and derivatives speculating to the downside. The bears are out to play and are having fun. Central bankers have learned to stay out of the woods at picnic time.
Sterling hasn't been so low against the Dollar, since December 1984, pushing on to near parity within months. The currency rallied towards the end of the decade as the Bank of England hiked base rates to slow an overheating economy. Sterling pushed higher back towards $2.00 within a few years.
In the eighties of course, the Chancellor of the Exchequer determined interest rate policy. It is different now. The Bank of England has the mandate. A point the governor was anxious to assert this week. Mark Carney told an audience in Birmingham that he would not take instructions from politicians on how to do his job. Theresa May had been critical of monetary policy in general and QE specifically in recent weeks, a clear challenge to Bank of England independence.
Closing at 1.10 against the Euro, the EU currency moved down against the dollar. The Fed is talking about a rate hike in December. The ECB shows no sign of a move. Short rate trends are against Sterling as we play "How low can it go". Short rates, money supply, inflation trends, capital flows, purchasing power parities, fundamental equilibrium exchange rates, lots of classical theories to model exchange rate moves. Nothing in the text books about Brexit and the potential loss of reserve currency status. Sterling is unloved by markets, abandoned by government and the central bank.
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And what of inflation ...
Inflation is set to rise significantly and within months. The Bank of England model assumes currency depreciation impacts on inflation within a two to three year timescale. It is nonsense of course. Marmite, you may love it or hate it but the trade spat between Unilever and Tesco demonstrates the immediacy of translation of import costs into the CPI index.
Oil price rises and the currency fall, will increase fuel price pressures by over 30% this quarter and by almost 80% in the first quarter next year. Manufacturing input costs already rising by 8%, will rise higher, pushing manufacturing output costs higher too. The feed though of petrol prices, commodity prices, food and beverages may push CPI inflation above 4% in the first quarter next year. The governor has suggested the MPC will "look through" any inflation rise to defend growth and jobs. Once the Fed begins to make the move to increase rates in the U.S. there may be little option.
An what of depreciation? There is no benefit to the economy from a weakened currency. Import costs rise, increasing inflation with little or no price or substitution effect. Demand for imports is relatively inelastic with regard to price. They form a large component of exports in any case. The correlation between export and import growth is over 99%.
As for exports, most exporters will price in currency and price to market. Margins are enhanced by depreciation, to offset rising costs. Price elasticity suggests a 10% fall in currency leads to a 6% increase in volume at best. There is no point changing currency prices. A falling currency is not good for U.K. business. For those pricing in Sterling, any volume thrill is extinguished by margin squeeze as costs rise.
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So what of construction ...
Construction output increased by just 0.2% in August year on year. We expect little growth for the year as a whole. It really is a tale of two sectors. Private sector growth and public sector contraction. Nothing to do with Brexit as the ONS makes clear.
Private sector housing activity increased by almost 10% in the month. Commercial real estate growth increased by almost 4%. The era of the £50k brickie has returned. Our "brickies cost per 000" index is rising to record highs, signalling price and earnings inflation in the housing sector. Private industrial work fell by 13%. It is a small component in the overall volume of activity perhaps demonstrating the weakness of manufacturing investmen.
The major falls in activity were in the public sector. Infrastructure activity fell by over 9%. Public sector housing fell by a similar amount. Nothing to do with Brexit. Tory austerity and spending cuts are to blame. There are little hopes of big infrastructure spending to be announced in the Autumn review. Shovels at the ready ... the construction sector awaits the call.
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So what happened to Markets?
Markets, were mixed - The Dow closed at 18,212 from 18,195. The FTSE closed up at 7,044 from 6,899.
Sterling fell against the Dollar to $1.220 from $1.246 and fell against
the Euro to €1.110 from €1.115. The Euro fell against the Dollar
to 1.099 from 1.117.
Oil Price Brent Crude closed at $51.69 from $51.77 The average price in October last year was $48.43.
Gilts
- yields moved up. UK Ten year gilt yields closed at 1.10 from 0.97. US
Treasury yields moved to 1.77 from 1.740. Gold closed at $1,251 from
$1,314.
John
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