Thoughts through the cycle: W3 May ’20

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  • Those who are ignorant of history are condemned to say pithy things about it. It is an odd phenomenon that as soon as something bad happens, there is a general tendency to scrabble around in history books to find the most recent precedent or, if events are sufficiently bad, to find the worst case in history and have this act as some kind of yard-stick. There have been several ‘great recessions’ since the great depression, each one being compared to the 1930s but never being quite as bad. Suddenly there are experts on the 1918 Spanish flu everywhere.
  • When people think about the British pound in crisis, inevitably the first port of call is the 1992 ERM (Exchange-Rate Mechanism) crisis which made George Soros famous. While the pound collapsed, this was not really a sterling crisis of the sort that spasmodically occurred after 1945. Britain joined the ERM in October 1990, late and with an ill-advisedly narrow trading band against the West German Deutschmark. As recession set in, maintaining the peg required ever-higher interest rates which crippled the UK economy and drove much of the residential housing stock into negative equity. When the UK tumbled out of the ERM on ‘black Wednesday’ (16/09/1992), the pound stabilised lower and the subsequent economic recovery was strong and broad-based.
  • Black Wednesday was due to a poorly-conceived currency peg. The last ‘real’ sterling crisis culminated in 1984 (see graph below) with a buyers’ strike in the gilt market. Rumours were afoot that the Sultan of Brunei was going to move £10bn from sterling into dollars which would likely have meant the pound broke parity against the dollar. The Sultan was eventually persuaded to keep his money in the UK. The ‘broker’ in the deal was none other than Mohamed Al-Fayed, and his reward was being allowed to buy the Harrods department store from under the nose of the infamous corporate raider, Tiny Rowland. The Monopolies and Mergers Committee fabricated a conflict of interest to block Rowland’s bid due to his ownership of Dagenham Nylon, a manufacturer of ladies’ undergarments. Such was the free market in the 1980s.

Source: GBP USD Spot, Bloomberg,14th May 2020.

  • Why the dinner party anecdotes on 1980s currency movements? As the UK moves towards ending the pandemic lockdown, there is already a sense that the UK Treasury Department has started to think about how to pay for all the lockdown-related largesse. The furlough is to be extended to October, albeit at a lower rate of 60% of wages, not the current 80%, from August. The Treasury has a base case cost of £337bn, and a worst case of £516bn. Leaked documents to the Daily Telegraph appear to suggest the Treasury is already thinking of ways to pay the bill through an assortment of tax rises and pay freezes.
  • Cue outrage. The Daily Telegraph quotes an anonymous central banker (possibly the only one who doesn’t want to hog the lime-light) as saying, “It is crazy. We should be cutting taxes to support the economy as we slowly come out of this….The idea that we need significant spending cuts or tax rises is completely wrong. The debt will take care of itself.” (‘The Treasury is wrong: we don’t need hair-shirt austerity’, Daily Telegraph, 14/05/2020).
  • In a sense, this banker is correct – austerity is not the only option to close a primary deficit. There are in fact four, of which austerity is one. The rest are as follows: default and restructuring of debts, aggressive taxation of the rich and/or corporates inflating the debts away. Clearly each creates its own winners and losers. Someone has to pay. At the moment though, it seems that we are just choosing to run bigger deficits. This is fine so long as borrowing costs stay low – and so long as the Bank of England sticks to unlimited quantitative easing (QE), which it is going to do.
  • In a statement on Thursday 13th May, the new Governor of the Bank of England (BoE), Andrew Bailey, said the central bank could help avoid austerity and that, “One of the reasons that the Bank of England [is] acquiring a much larger stock of government debt than … would have been imagined [a decade ago], is that what we can do, providing the overall credibility of the framework remains in place – and independence is very important to that point – is that we can help to spread over time the cost of this thing to society and that to me is important. We have choices there and we need to exercise those choices.”
  • The Bank of England base rate is at 0.1% and nominal yields on the gilt curve can be controlled by central bank purchases, so the government can run whatever deficit it chooses. Simple. Bailey also added that the BoE wouldn’t adopt negative rates and that it was, “not something we are currently planning or contemplating”. He added though it is, “always wise not to rule anything out forever”. Sensible stuff, until you realise that 2yr gilt yields are already negative, as per the graph below:

Source: Bloomberg,14th May 2020.

  • As debt-deflation sets in, the UK curve inverts even with the base rate at 0.1% (£6m is at 0.14%, 2yr is at -0.02%). Inverted curves restrict bank lending as it is no longer possible to borrow short and lend long at a profitable rate. The BoE will therefore likely have to take rates negative at some point if they don’t want bank lending to be constrained. They may deny this, but it will happen as the market is telling you it’s coming. ALL of this is the consequence of a build-up of debt, and while deficit-financing may seem expedient in the short-term, there is a price to pay, as high debt means low growth, and low rates reflect tight, not easy, monetary conditions.
  • So when the Governor of the BoE says no negative rates and the market tells you we already have them, and when central bankers say that debt takes care of itself and that the idea of austerity is, as Kim Kardashian might say, totally cray-cray, one ought to be cautious – nothing is ever that simple, and there is always a price to pay somewhere. The price of financial repression is easily understood – you can control the price or the quantity of money, but not both. When the BoE says it’ll do unlimited QE, it is controlling the price of money.
  • This is where the quaint story about the helpful Mr Al-Fayed becomes relevant. If you are using aggressive deficit financing and financial repression while running a current account deficit (this is what the previous Governor of the BoE, Mark Carney, described as the ‘kindness of strangers’ when foreign investors lend to the UK for its consumption), there is a tendency for the currency to fall to compensate for the build-up of debt. In a global economic experiment of historic proportions (historic insofar as the quarantining of a whole workforce and the government stepping in to pay all the wages having never been done before), then there is clearly a risk to the pound. Add in the prospects of a cliff-edge Brexit decision being made in the next month or so as negotiations with the European Commission flounder, then there is a genuine possibility that the pound could get torched in a way that hasn’t been seen in decades.
  • The story of the pound in the mid-1980s is really quite parochial. The real story then, as now, is the dollar. The Fed under Chairman Paul Volcker crushed inflation through rate hikes, and the dollar soared as a result. The strong dollar eventually became a problem in itself, ending in the Plaza accord of 1985 where the main central banks in the free world agreed to sell dollars (and let this be known), thereby weakening the dollar. It is worth noting that the central banks of the US, UK, West Germany, France, and Japan were cold-war allies, acting multilaterally. We are now in the era of ‘America First’, and this is an age of unilateralism.
  • The dollar is the de facto global reserve currency, and the currency of international trade. This generally means there are never enough dollars around if trade is expanding, and certainly not enough when revenues are collapsing and lenders are calling in loans and/or charging more for debt to be rolled. The US primary deficit could top 30% this year, and without Fed QE, this deficit will crowd-out the private sector. Crowding out may still happen despite the Fed actions. The graph below shows the U.S. Dollar Index (DYX) in a narrowing wedge, a price formation which generally marks a breakout. In this case, the breakout is likely to be higher (note how the DXY is strong DESPITE the monstrous Fed and Treasury cash-splurge which is magnitudes higher than any other country – this just shows how short the world’s dollar position is).

Source: Bloomberg,14th May 2020.

  • The strength of the dollar is the most important macro-economic data point of them all. It becomes critical when the US President seems to be initiating a cold war on China. The US government is now actively trying to reduce US financial investment in China, and is increasingly looking to weaponise the dollar. A sense of the tone emanating from the White House can be garnered from the Bloomberg headlines below (14/05/2020).





  • China’s currency is pegged to the dollar and its capital account is closed, meaning it relies on the dollar for purchases of commodities, especially oil. There is a clear risk here that the dollar rises sharply against all the other major currencies, but that aggressive policy moves from the US with respect to China could exacerbate this. All else equal, a strong dollar is deflationary and negative for growth, not exactly what you want when the world is in the grip of a severe recession.
  • Back to the pound. What is important to consider is not whether the government is making the right decision on lockdown, furlough, testing, or any of a myriad of complex, inter-linked issues relating to the Covid-19 virus. Everyone can have a view on that. The big question is this: if the decision to deficit finance with the central bank simultaneously applying financial repression (capping nominal gilt yields), then what is the consequence? We clearly believe the pound is at risk. If the pound really starts to move, does this start to affect monetary policy (emergency defensive rate hikes anyone)? Might it then affect fiscal policy (restricting government deficit spending)? This an economic experiment of immense proportions to the backdrop of a highly-indebted public and private sector. While it is comforting to think that governments and central banks are always in control, ultimately it is left to markets to decide. You can control the price or the quantity of money, but not both. Sound as a pound?

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