Friday is stress test day in Europe and UK economic growth surges in the second quarter of 2010

23rd July 2010 by Shaun Richards

After a Wednesday which was dominated by Ben Bernanke (head of the Federal Reserve,America’s Central Bank) and his use of the words “downside” and “unusually uncertain” we saw something of a change yesterday. Equity markets surged regaining all the ground lost the day before and indeed more. You might wonder why they bothered falling in the first place but that is one of the wonders of market behaviour. The Dow Jones Industrial Average rallied some 201 points, the German Dax index surged some 152 points (2.53%) and not to miss out the Japanese Nikkei index something of a laggard recently rose 210 points. These sort of moves intrigue me when they happen as we are given an insight into market psychology which appears to have been itching for a rally almost regardless of logic or what news occurs. There was some better news for example the European Purchasing Mangers Index produced some numbers which were better than expected for both manufacturing and services and UK retail sales also surprised on the upside. However I am always cautious about survey results (PMI) and retail sales is a rather erratic series, but apparently equity markets had other ideas.

Equity and Government Bond Markets

It is often true that these markets operate in opposite directions. To explain this imagine an economy that is growing strongly and think of its equity and government bond markets. In such a scenario one would expect equities to be doing well as hopes for the future will be high leading to expectations of higher dividends and capital gains but the attractions of receiving fixed coupons from a government bond every 6 months are likely to be less attractive and so bond prices are likely to fall until the yield received is more attractive. In a slowdown for the economy then government bonds are likely to rally as fixed coupons (a fixed interest rate) look more attractive whereas an uncertain or declining outlook will encourage people to sell shares. Some investment house will explicitly trade this argument as in switching from one asset class to the other. If I may add an additional level of complexity in the real world then such investment decisions will be affected by expectations and opinions as much as reality but the principles remain clear.

There are scenarios when both assets classes may rally or decline together. For example in recent times Greece has suffered periods where her equity and government bond markets have fallen together. In essence at times her outlook has looked so poor that all Greek financial assets have been sold. It is possible for both to rally too for example imagine say the discovery of a new advance, for example if cold nuclear fusion was discovered to actually work ,which would project the world onto a higher growth lower inflation scenario and be good for both asset classes.

I have explained these concepts because yesterday reminded me again that at the moment the relationship between equities and bonds appears to me to have broken down. In essence they are telling us quite different things and both cannot be correct. This of course leads to the question which one is? Or of course neither!

If we look at the US government bond market then let us start with her 2 year bond. This is yielding 0.56%. Please consider the implications of this from the standpoint of the person who is buying these. For whatever reason they must have quite an apocalyptic view of the US economy over the next two years to accept this as a return. In real terms even accepting official figures for US inflation (which I challenged on July 2nd) you will have a negative return, if you take my suggestion for US inflation your return is even more negative. I suppose if you are a foreign investor you may hope for a return based on a rally in the US dollar exchange rate but any domestic investors have no such refuge. If we move further down the yield curve then even when we get to the ten-year maturity currently you only get 2.94%. Investors are accepting these yields and just as an example the US Treasury plans to issue some 38 billion dollars of two-year bonds on Tuesday the 27th.

For UK readers the situation may well be even more concerning. Our two-year government bond yield is 0.76% and any complacency that this is at least a little higher than that of the US is immediately punctured when you look at our inflation performance. This was described yesterday in an interview with the Independent newspaper as “higher than expected” by the Bank of England’s Chief Economist Spencer Dale and is either just over 3% if you believe in our CPI measure or 5% if you are still a fan of the retail price index. Even Mr.Dale is predicting that inflation will remain higher than target through the next eighteen months, although cynics who look at his forecasting record may see signs of hope in this.

On the other side of the coin we have equities rallying. Having seen an extreme example of this yesterday it reminded me of the levels we are now at. If one considers the whole equity rally since the falls at the height of the credit crunch it has gone quite a distance and yet it must be driven by quite different views to those in the bond paragraph above. If we consider this from the perspective of the German Dax equity index it fell to below 3600 back at the height of the panic in spring 2009 and as I type is at 6184 an increase of the order of 70%. Other equity markets have also surged over this period although maybe not to the same extent. Put the thoughts behind this into the bond paragraph and there is a clear dichotomy in my view. We are in a period where there is a major dislocation between the views implied by these two asset classes. This is troubling at best and is a clear amber light for our current situation.

Stress Tests in Europe

Today at 6pm in Europe and 5pm in the UK will see the results of the stress tests that have been conducted on 91 banks in 20 countries in Europe which represent around 65% of the European banking system. I counsel some caution on these as the tests have been constructed by a European organisation (CEBS) which appears to be more civil servant than market participant based. So far this has shown signs of being badly handled as for example.

1. It should be released outside market hours not inside them, America will still be open and some equities trade there.

2. There has been leak and counter-leak during the run-up to this including some particularly shameful efforts by euro zone ministers (Elena Salgado of Spain comes to mind). Security in future needs to be improved.

3. Generic information will be released first with specific individual bank data released a little later. To my mind if you are going to swamp people with data you may as well completely swamp them and let them pick and choose what they read.

4. The criteria should have been announced in advance. This would increase credibility and transparency.

Dangers of such an experiment

The obvious danger is that the tests are set so that everybody passes. Such a result would make the whole operation valueless in my view as even the most credulous would not believe that. There are clear outliers in European banking on whom eyes will fall very quickly for example Hypo bank in Germany,some of the Spanish cajas and the Greek banks. Because of the leaks this picture is somewhat muddy and has already eroded some credibility for if what the Spanish Finance Minister said on Tuesday is true then the 8 private banks and 18 cajas tested in Spain all passed.

There is a more fundamental problem with the whole concept which goes as follows. The last couple of years have seen stresses on banks and economies arise which are dynamic,fast-moving and have impacts in many areas at once. By their very nature stress tests are static and partial. So if you are a believer in “Black Swan” events or what I was taught as the serially uncorrelated error term at the LSE then a stress test will be of little help to you I am afraid and in fact can never be. In the world in which we live unexpected events appear to be occurring more frequently and their impacts appear to be becoming more dynamic. Even so I will be taking a look at the figures as they will provide (hopefully) some useful information.

UK Growth figures surprise on the upside

In general figures for UK growth were expected to be good. Many felt that they were as likely to be as good as we will get as they predate the austerity measures which have more recently been imposed. In the event I cannot think of anybody who expected growth in the 2nd quarter of 2010 to be as good as it turned out. The initial estimate from the Office of National Statistics (ONS) is for growth of 1.1%. Particularly strong performances came from services and construction each of whom contributed some 0.4% to the growth.

I am always cautious about economic figures and first estimates on GDP growth can be unreliable. They represent two months (out of the 3 in the period) information on 40% of the data set and three months data for around 20% of the data set. Also remember that the ONS had recently to delay the issue of the final estimate of 1st quarter GDP because of problems it has failed to properly explain.If you break the numbers down then the improvement in construction which looked at as a segment on its own grew by 6.6% is explainable by the cold weather and snow we had in the first quarter. So without the snow maybe some growth would have taken place in the first quarter that is now being recorded in the 2nd. Such an exchange would make the figures look more balanced.

Personally I would rather enjoy the figures for now and hope that they are true as we will need every scrap of economic growth we can get over the next year or two. I will try to ignore the concern ticking around in the back of my mind that over the years things which look too good to be true usually turn out to be so.

The figures add to the dilemma faced by the Bank of England and indeed her Chief Economist Spencer Dale. For the MPC in its minutes of its last monthly meeting which were released only on Wednesday did discuss further expansionary measures (“modest easing”) as it felt economic growth would be lower. 

The prospects for GDP growth had probably deteriorated a little over the month……..In the light of the news over the month, it seemed likely that growth would be weaker than previously expected

In his interview with the Independent newspaper printed yesterday Spencer Dale suggested this.

there are some signs that growth may be softening

Not quite Paul the Octopus is he?

As I final thought I wonder what those who own shorter dated UK government bonds think of these figures..

8 thoughts on “Friday is stress test day in Europe and UK economic growth surges in the second quarter of 2010”

  1. Abel says:

    Despite reading your excellent blog daily for the past 6 months and having an ok understanding of economics, I am still completely unable to understand how sovereign debt works in the US and I was hoping you would be able to explain it to me.

    * What is their budget deficit
    * What is their Sovereign Debt compared to GDP
    * Who buys their bonds? Especially now that China is starting to diversify her risk to other currencies (the Japanese currency I think you mentioned)
    * How is it sustainable – do they have enough internal wealth to keep it going adinfinitum?

    Would really appreciate an explanation as I just can’t get it!

    1. Hi Abel and welcome
      In terms of numbers the US is likely to run a fiscal/budget deficit of 11% of GDP and her national debt is 83.2% of her GDP according to the IMF. As to who buys her bonds then whilst Americans and their investment/pension funds do buy her bonds she is reliant on overseas purchahses which will involve sovereign wealth funds. China is probably a decent buyer but figures for those sort of thing are in my opinion very unreliable, for example recently China appears to have been buying via the UK which distorts the figures.

      In terms of making it sustainable then there is really only one answer now and that is economic growth preferably lots of it. Otherwise it looks much less likely that it is sutainable.

  2. robert mcgrath says:

    I am a relatively new reader of your blog, and I’ve got to say I do enjoy them even though I am not an economist. I think I enjoy them because a very wise scientist told me many years ago apropos giving seminars: “If you tell people just one thing they didn’t know and that they understand they will go away happy”.
    I’m sorry I’m not really in a position to make useful comment, but is there any reason why the US can’t buy its own bonds? I mean just to get the ball rolling, like the sharks at town fair auctions?
    As a retired scientist I must say I feel as if I am watching experiments in alchemy when I try to understand economics.

    1. Hi Robert
      I wouldn’t worry too much about thinking there is some alchemy going on in modern-day economics, I think so too! How about stress tests without any real stresses?

      As to buying your own bonds which both the UK and US have done recently there are two main issues. We both have to sell some of our government bonds abroad. That does not mean that we do not have domestic savers or pension funds that do buy them merely that we do not have enough. Indeed with the large expected deficits we both have then we are likely to be rather reliant on overseas purchases of our bonds over the next few years and we both have overseas holders of our existing bonds (around 30% in the UK). Think of it now from their perspective. They know that this is a risky experiment and they must to my mind have a lower view of us then before. So there are dangers here for their willingness to invest in us in the future. I thought that this would impact this year on bond yields but I have been proved wrong as spring turned to summer by the way that “flights to quality” effects have affected both US and UK bond yields favourably. So I feel that we will have to wait for the full impact of this until the world economy begins a more sustained recovery and risk,fear and contagion are no longer driving forces. Put more simply I think that it has been a fluke that QE has not been viewed more unfavourably as the political stability and safe haven status of the UK and US has outweighed “bond economics”.

      Another way of thinking of this is saying why do you not buy your own mortgage? The problem then is getting people to trade with you and give you credit etc. Of course you may have to get them to stop laughing first at the idea…

      Now if you look at the second issue which is the domestic economy. If we ignore the concept of sterilisation and look at pure QE then what is happening if you buy your own bonds? The first move is that your central bank is creating money and exchanging it for debt. So the money supply is expanded. There are many different theories on what the impact of this is but if you pump extra money into an economy there are two main possible effects a rise in output and/or a rise in prices. I personally feel that the links between pumping this sort of money into the economy and output are weak at best and that this has so far been demonstrated by how the US and UK economies have responded. However there have been signs of an impact on prices in the UK (and if you read my article on US inflation more there than you might think). To my mind there clearly have been effects on asset prices such as the stock market and in the UK on house prices and maybe in some commodity prices which are to my mind much higher than you might expect considering the fall in world output. So even at a time when you might think that expanding the money supply is least likely to raise inflation I would contend that it has done so, and I am using a wider definition of inflation here than just a consumer price index.

      Now here is a question which I do not believe those in favour of buying your own bonds have ever properly answered. When things get better what is your strategy?

      I hope that this helps. There are issues here that do not have a definitive answer. The phrase “a dismal science” does apply to economics here, not necessarily that all of it is dismal but that you never actually get a definitive answer in the way that a scientific experiment might give you. You can never factor out one variable and isolate it as there are always other factors. For example if we take money supply you might think that this is easily calculated but once you get from base or high powered money (which the central bank sets and therefore should know) it is often not so clear how you define things and then calculating it.This is rarely discussed but is true, I suspect it is rarely discussed because many of those who look at it do not understand it. So far with the lags in monetary policy the QE experiments in the UK and US have probably had about 2/3 rds of their effect so some is still unknown…

      As to buying your own bonds I think part of the answer comes from thinking of it as a complete concept, as in if it is such a good idea why has it not been done before and why do we and the US not buy all of our own bonds? We need not bother then with such inconveniences as foreign investors and adverse change in interest rates, we could set whatever ones we liked. Here I think becomes the beginning of the rub to me as in it is a part of a fantasy that currently exists in the real world.

    2. DanielC says:

      What a great response Shaun.

      Someday if you are “stuck” for a post topic, might I request in advance:

      – the whys and wherefores of monetizing debt. How much can a CB “get away” with, how much is truly harmless or perhaps even desirable, when and how does it start to become troublesome? Is not a CB buying bonds on the open market synthetically equivalent to directly monetizing that amount anyhow, i.e. is the aversion to a CB buying some of a new issue a false dichotomy along the lines of “dividend vs capital income”?

      – with potentially “too much” money out there in the banking system from Q.E. but inflation not yet really hitting, what might be the mechanism and trigger for it to take hold? And when that happens is there anything a CB could do about it at that stage? While I think “Inflation is always and everywhere a monetary phenomenon” is an awfully good starting point, I suspect that there are important and useful details beyond that; e.g. rather than inflation being rigidly connected to quantity of money I suspect the connection is more like (analogy alert) springs of dynamically varying stiffness?

  3. paul cousins says:

    what is your veiw on the UK GDP figures for the coming 5 years of the UK having to import most of its gas ,oil and coal? a GDP raise of 1.1% pa may look like the good times…

    I don’t see us making much of anthing to pay for such imports I’m afraid. ( take into accout we import most of our food as well).


    1. Hi Paul
      I do not think that even in more stable times it is possible to predict 5 years ahead with any accuracy. It is currently not possible to forecast 5 months ahead in some ways in my view because of what is going on. At this time there are many cross-currents affecting the UK economy and many are hard to predict. My forecast for this year has been hit in the first and second quarter ( I take ONS numbers even if I am unconvinced by them as otherwise it is too easy to reject the ones you do not like and accept dubious ones that fit a theory….).

      As to imports of energy then there are big issues here. One of the “commenters” on here is very concerned about it and contacts me from time to time on this issue. He works in the area of energy supply and sees big dangers for us from it. I also remember the US department of defence predicting problems for energy in 2012. As a big energy user they had no great reason to do this ( unless of course Iran actually is next….).

      With or without oil there are clear issues going forward. The world hit trouble in 2007/08 but we have seen little or no reform. So we are mirroring in many ways how Japan responded to her crisis. Now there are clear differences between us and them but there are also some similarities which is why a type of stagflation looks possible to me.

      I do realise that you can find people who are willing to make long-term forecasts. I saw someone who has recently appeared everywhere on the BBC do such a thing last week and then one of the accountancy firms (Price Waterhouse) did something similar in the Sunday Times. My response to those is simply that they do not know that.

  4. seanbroseley says:

    Comments towards the end of this article by William Keegan raises an interesting possibility:

    And giving this further context:

    Interesting that the GDP figures should surprise on the upside not longer after the recent delayed announcement because of a possible error.

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