Russell Silberston

‘It’s good to talk’ was an award-winning 1990s advertising campaign for BT, fronted by the wonderful and much-missed British actor Bob Hoskins, in which Bob tried to convince Britain’s taciturn men to spend more time on the telephone.

Central banks also discovered the delights of more communication around the same time, believing that speeches, press conferences and interviews were valuable tools that helped to anchor the public’s inflation expectations and the market’s view of future policy.

Such guidance has been invaluable in the recent and historically fast interest rate cycle, enabling the public to understand by how much interest rates are likely to rise and more importantly why this is necessary.

Equally, guidance has tightened financial market conditions quickly, transmitting monetary policy through to equity and bond markets and so on to the wider economy.

The US Federal Reserve (Fed) has been an exemplar of this strategy, being up front with the public about the costs of its action and explaining how, while it understands that these actions affect communities, families, and businesses; restoring price stability is essential for achieving long-term maximum employment.

With respect to financial markets, the Fed told us clearly that policy initially needed to get to a more neutral setting (from super loose) and then to restrictive levels.

Once the Fed reaches the latter point, it will be necessary to keep rates there until it is confident that inflation will return to target. Bob would have admired the Chair’s straightforward language.

However, one dreads to think what he would have said about the Bank of England’s communication efforts. In its recent press conference on the 9th of August, a simple word count of the transcript records that economic models were mentioned 22 times. The same exercise for the Fed records no use of the word model in the past three press conferences.

This modest exercise reveals the source of the Bank’s current problems, namely an over-reliance on economic models for policy making that are just not fit for purpose in the post-Covid economic environment. Setting interest rates based on a modelled output of medium-term economic growth and inflation is difficult in benign times. Over the past three years it has been impossible.

The Bank, however, has belatedly recognised this problem, but rather than develop a new strategy to deal with the huge uncertainties that have shaken the global economy in recent years, it uses discretion to tweak its modal, or most likely, forecast to try and account for the opaque future.

The Bank’s defence is, to quote from the August press conference, ‘there are always judgements. The forecasts are rightly described as the best collective judgement of the committee. The models are a guide.’ Perhaps then the judgement has been incorrect?

The Old Lady’s problems are compounded by an absolute refusal to discuss where it thinks neutral interest rates are. Simply put, this is the level of interest rates that are consistent with growth at trend and inflation at target. Anything above this level should slow growth, anything below stimulates. The Bank’s counter is that neutral, or r-star is a largely theoretical concept and can only be validated ex-post and as such trying to define it precisely can be misleading.

However, for financial markets, r-star is a key input into pricing of long-term interest rates and provides an anchor for mortgages and corporate loans. Without this anchor, longer-dated interest rates become unmoored and so more volatile. This effect can be seen clearly in the UK mortgage market, which is priced off UK interest rate swaps. At their peak in early July 2-year swaps were 123 basis points above Bank Rate.

The equivalent in the US at the time was 22 basis points under Fed Funds and in the Eurozone, 44bps above official rates. At the end of the first week of August, they remained 34 basis points above the recently hiked Bank Rate versus -63 bps and -2 bps in the US and Eurozone respectively. In the medium term, there is a 94bps range in the Bank’s own survey of where market participants expect Bank Rate to settle. In the US, the equivalent range is just 13bps. This unmooring of expectations, stemming from a lack of conversation about neutral, has real world consequences in the form of higher borrowing costs.

If the Bank is struggling with modelling the economy and refuses to counter an anchoring of markets around neutral interest rates, then it should be guiding the public, markets and business with clear and concise communication. Unfortunately, it appears to fall here too. Using AI, (ChatGPT), it is possible to assess the complexity of the Bank’s Monetary Policy Summary, the concise 800-word publication used to inform the world about the Bank’s latest world view.

This document is assessed as ‘intermediate’ and ‘contains a mixture of complex and straightforward sentences, technical terms related to monetary policy, and economic indicators.’ Compare this to the Fed’s own statement, which is assessed as ‘intermediate, relatively low’ consisting of ‘short, straightforward sentences with simple language and uses common financial and economic terms.’

There can be little doubt that the Bank’s rate-setting process has been sub-optimal. And attempting to defend it by saying we have seen unprecedented shocks doesn’t stack up when the whole world has experienced the same. So, what happens now? To an extent, matters have been taken out of the Monetary Policy Committee’s hands and their own governing body, the Court, has helicoptered in Ben Bernanke, ex-Fed Chair, to undertake ‘a broad review into the Bank’s forecasting and related processes during times of significant uncertainty.’

Looking forward, expect the Bank to move toward the Fed’s model of clear and simple communication, with less emphasis on models and more on anchoring market expectations. Perhaps they could save Bernanke’s fee and just watch those old adverts with the excellent Bob Hoskins. When it comes to monetary policy, It’s Good to Talk.

By Russell Silberston, investment strategist 

The post It’s good to talk appeared first on AdviserVoice.

From 1870 to 2015, it’s estimated that the global housing market returned 11.06% per annum, or 7.05% in real terms. Impressive when we compare that to the more volatile and more modest 10.75% return from global equities over the same period. It should come as no surprise then that the phrase “as safe as houses” has entered the common lexicon.

What people may not know, is that that period also captures one of the greatest housing downturns in history which scarred the US economy with a deflationary shock for nearly a decade and left many questioning the validity of property as an investment.

This begs the question, are houses as safe an investment as some like to suggest? And more to the point, what are the economic implications when things go wrong?

Looking back it is easy to see the imbalance that was building within the US economy in the lead up to the Global Financial Crisis; real disposable income ratios peaked at 1.1 times and household debt to GDP reached 99%. It seems incredible then, that after many years of low interest rates and cheap money globally, certain countries have repeated these errors of the past leaving household balance sheets on the brink just as central banks commenced the fastest policy tightening cycle in history.

Specifically, we identify six countries that face particular challenges: Australia, New Zealand, Canada, South Korea, Sweden and Norway. These economies never really delevered after the Global Financial Crisis, as the US did, and as a result have seen housing markets continue to inflate and household debt balloon. Real house prices to real disposable incomes for example in the three-dollar bloc economies (Australia, New Zealand & Canada) are around 2.5x with household debt at or above 100% GDP. While debt levels are lower in the Scandinavian countries, with nearly all household debt having floating interest rates in Norway and the highly controlled Stockholm market seeing especially exorbitant prices in the city, these markets are vulnerable to rising rates too.

In a world where central banks are still battling to control inflationary pressures the impact of these imbalances may well become critical in turning the tide. As interest rates rise rapidly and banks tighten lending standards, these economies face significant headwinds to both growth and inflation as consumers try to overcome the hit to their disposable income.

Typically, as housing demand fades, leading indicators such as new housing starts fall and property prices turn over, feeding directly into inflation and growth. This is further exacerbated by the negative wealth effect on consumption and broader use of debt. Rising interest rates drive a tightening in bank credit standards, making any new loan or re-mortgage that much more expensive weighing on consumers disposable incomes and undermining consumption. As growth and inflation fall, central banks are ultimately constrained in their ability to raise interest rates.

This is precisely what we are seeing in these vulnerable markets. In both Australia and Canada, for example, housing starts have fallen 33% from the post Covid highs, and property prices are well off their peaks in both countries. The Reserve Bank of Australia, therefore, slowed the pace of interest rate hikes and began to look towards a pause stating in its latest meeting that “Growth over the next couple of years is expected to be below trend. Household consumption growth has slowed due to the tighter financial conditions and the outlook for housing construction has softened.” The Bank of Canada has similarly held at a level 1% below where we project Fed Funds to reach. Meanwhile, on the other side of the world, Sweden’s Riksbank is trying to find the line between the prospect of “falling house prices leading to lower housing investment, which will reinforce the economic downturn” and a weaker currency.

For reference, we see the UK housing market as falling somewhere in the middle of these dynamics; while it hasn’t inflated as much as the economies highlighted, households have failed to delever to the same degree as the US. With housing associated activities making up over a quarter of domestic GDP it is likely that we will see some impact closer to home.

Thus, we would be surprised if, as higher interest rates begin to bite, those economies that have grown material household and housing market imbalances over the past decade of easy money don’t find themselves exposed to notable downside surprises in both growth and inflation over the next 12-18 months. We believe this presents opportunities in government bonds in these markets and is likely supportive of currency depreciation in these nation’s currencies against structurally stronger reserve currencies.

The post Macroscope: As safe as houses? appeared first on AdviserVoice.