Lost interest? | 23rd June 2014
What do England’s exit from the World Cup and a pending interest rate decision have in common? | Since Mark Carney hinted that UK interest rates might rise by the end of 2014 in his Mansion House speech on the 12th June, Sterling has strengthened, reaching a peak against the Dollar last seen in 2009. By the end of the week, Sterling had slipped back slightly and the debate had focused again on how this would affect the enduring problem of UK growth: that without a seismic shift in the productive, and hence export, capacity of the economy, any chance of sustainable recovery remains in the hands of Britain’s consumers. In essence, this is the same as leaving the chances of getting out of the group stages of the World Cup to Italy or Costa Rica. And we all know what happened there.
It is a mistake to think that interest rates changes are going to make much difference to exports at all. For example, the correlation of the USD-GBP spot with exports is only 0.41 while for the GBP-Euro rate it is 0.46. Similarly imports are only 0.38 correlated with the USD-GBP spot and 0.56 correlated with the GBP-Euro spot. In other words, don’t expect interest rates to make much difference to trade at all.
The mystery is why anyone should be surprised at this. Figure 1 shows the two currency spot rates (USD per Pound Sterling and Euro per Pound Sterling) against the one-month Libor rate.
Figure 1 | The USD-GBP and GBP-Euro spot price, Last Price Monthly, June 2001-May 2014
Source | Bloomberg
Over the time period, the volatility in base rates is relatively clear to see, as is the dramatic drop in interest rates to near zero as a reaction to the financial crisis. The substantial reduction in the value of Sterling against the dollar and the Euro between 2007 and 2009 can also be seen. And although there has been a slight improvement in the value of Sterling against both currencies over the past 12 months, this is both independent of interest rates, since these have not changed and, more importantly, in no sense a recovery to the pre-crisis levels. What is interesting about Figure 1, however is the fact that the relationship between interest rates and the value of Sterling against the Euro is much stronger at -0.80 compared to short term interest rates against the value of the US dollar against Sterling, where the correlation is 0.64. In other words, UK interest rates are more likely to provoke a sharper correction of Sterling against the Euro than they are against the dollar.
But whether or not this will impact trade is debatable. Figure 2 shows the historical relationship between short term interest rates and trade over the period since 2001.
Figure 2 | The Value of UK exports and imports (USDm) versus short term base rates, June 2001-May 2014
Source | DeltaMetrics 2014, Bloomberg
Mark Carney is clearly correct to think he can gamble on raising interest rates and it having a minimal effect on trade: the correlation of short-term base rates with exports over the period is -0.18 while for imports it is -0.25. While this is, of course, purely for illustrative purposes, it points to something that economists have suspected for a while of UK trade: that a change in interest rates that leads to a change in the value of the currency will have little or no impact on levels of trade. There has been a near 25% reduction in the value of Sterling since 2008; there has not been a commensurate increase in trade.
Figure 3 illustrates how the Terms of Trade have changed against the value of Sterling against the Euro and against UK base rates.
Figure 3 | UK Terms of Trade versus GBP per Euro spot, Last Price Monthly, June 2001-May 2014
Source | DeltaMetrics 2014, Bloomberg
There is a strong correlation over the period between the strength of the pound against the Euro and the terms of trade of 0.75. In other words, if Sterling strengthens, then the terms of trade over the period will also improve: exports will become more expensive relative to imports. This would almost be a truism were it not for the fact that the equivalent correlation with the Dollar is 0.18 – i.e. there is practically no relationship at all. So why would there be such a difference between the two exchange rates?
Figure 4 | Why UK trade with Europe is more vulnerable to a change in interest rates
Source | DeltaMetrics 2014
First, Europe accounts for 43% of UK goods trade and the US 10%. The UK’s top sectors are medicines, oil (crude and refined), cars and turbo-jet engines and turbines. The US is the biggest destination for both pharmacueticals and turbo jets engines and turbines, and the third and second largest destination for crude and refined oil respectively. Nevertheless, thirteen of the top 3 export destinations for Europe’s top five products are in Europe, helping to explain why the value of Sterling against the Euro is more important than it is against the dollar to UK trade.
Second, the USD-GBP rate is used more for speculation. Across the piece, its correlations with trade are weaker: the Euro is a trade-based currency so Sterling’s value against it is determined by trade rather than by speculation. This may make UK export trade itself more vulnerable should interest rates rise.
Relying on small-scale and incremental interest rate changes is likely to have little impact either on the value of Sterling or on the UK’s trade. The reason for putting up interest rates is usually to quell inflationary tendencies by making the cost of borrowing more expensive. In this case, the goal will be to dampen pressure on house prices which may create unsustainable growth in the UK economy.
But look again at Figure 2 and the trend in exports since September 2011. The values are actual historical values of trade and while the seasonal fluctuations in trade are clear, what is also obvious is a downward pressure on the value of UK exports in US Dollar terms. In other words, we are already seeing disinflationary tendencies affecting the value of UK exports. If interest rates do go up, this puts further negative pressure on inflation, which could create similar downward pressure on UK export prices in spite of a strengthening currency. The danger then would be of deflation brought on by the very instrument that was meant to be a cure: interest rates.
As a recent leader in the Financial Times* pointed out, the issue is one of a large productivity gap between the UK and the rest of the world, particularly the US and Germany. This weakens our manufacturing trade position and, arguably, makes UK exports uncompetitive not in price terms but in terms of the added value embodied in our high-end manufactured goods.
As was pointed out in a previous Trade View, the correlation between skills and UK trade is low at just 0.54 compared to figures of between 0.94 and 0.98 in the US, Germany and India and unless this gap can be closed, our progress towards global high-end competitiveness will be restricted by our productivity base. Like the post World Cup inquest, maybe we should be looking at the drivers of our own weak performance and not at the dominance of foreign players in our markets.
* Leader (June 13th 2014) | ‘Carney’s journey from dove to hawk‘ Financial Times