Webcast 033 | Losing interest: why negative interest rates present a challenge to global growth

It has been a tough start to 2015: what will be the outcome of persistently low interest rates be? Rebecca Harding and Sarasin & Partners’ Subitha Subramaniam discuss the topic.


Webcast 033 Author  |  Rebecca Harding  |  CEO

Webcast 032 | Resurgent dollar is not good for business

The US Dollar has strengthened in March: Rebecca Harding discusses the consequences of a potential rise in US interest rates on emerging markets and the rise of the yuan as a major trade currency.


Webcast 032 Author  |  Rebecca Harding  |  CEO

Webcast 024 | Is global economics more important than geopolitics?

As we move into the final quarter of 2014 it’s time to take stock on what has been a disappointing year in many ways. Neither trade nor economic growth have been anywhere near as robust as many economists expected at the beginning of the year, and the final quarter of 2014 looks like it will be tougher rather than easier. Delta Economics is pretty bearish about the immediate future but are we missing some of the key economic facts that may make the picture look brighter?

Discussing this topic with Dr. Rebecca Harding and to sift fact from fiction is Dr. Andrew Sentance, Senior Economist Advisor of PwC and former Monetary Policy Committee member.


Webcast 024 Author  |  Rebecca Harding  |  CEO

United Kingdom, but the problems are the same

Why interest rates will stay on hold for at least 9 months |  UK markets started to rise as soon as the opinion poll gap between the “yes” and the “no” votes in the Scottish referendum widened. This was as much out of a sense of relief as anything else. A more considered, if slightly glib, response when the final votes were counted came from a BBC interview with a bond trader, his view was that it would be business as usual: markets would start looking back at “fundamentals” and price in a rise in interest rates early next year.

Delta Economics does not see a rise in interest rates as likely in the next 9 months. This is because the macro-economic fundamentals, specifically trade, are too weak for this to be an option for the foreseeable future. The reassurance that the United Kingdom will remain intact as a currency union may initially play well with market sentiment; however, over a longer time period of time the spectre of falling prices and the performance of real economy in the form of exports cannot be excluded from the Bank of England’s thinking on interest rates. Add to this three things: first, there will be a Westminster election in May 2015; second, between now and then Scotland’s membership of the UK is to be renegotiated; third, if there is a Conservative government after May 2015 then there will be a Referendum on EU membership in 2017. All of this creates enough uncertainty around investment decisions to render an increase in UK interest rates extremely inadvisable.

But leaving the politics on one side, the first reason for suggesting that the UK cannot raise interest rates is that there is evidence of disinflation in recent historical export trade figures. Nominal values of trade have been on a downward trend since October 2011 and the UK’s annual export growth in 2013 was just 0.3%. In current prices, Delta Economics is forecasting negative export growth in 2014 (-0.65%) and 2015 (-0.1%) as illustrated in Figure 1.



Figure 1  |  Value of UK exports, June 2001-August 2015, USDbn versus Euro per GBP, June 2001-August 2014
Source  |  DeltaMetrics 2014, Bloomberg

As Figure 1 also shows, there is a low correlation between trade and the value of sterling against both the dollar and the Euro. This indicates that there are no advantages to be gained from altering interest rates. Higher rates would not be a powerful tool to make imports cheaper and, as there are disinflationary pressures anyway, lower import prices may be something that policy makers should avoid. Similarly, higher interest rates may push up the value of sterling but could damage exports and will exacerbate deflation.

In any case, sterling’s value has risen against the Euro and the dollar over the last 18 months and it would be dangerous to accelerate the process too quickly. Illustrated in Figure 2 are the UK terms of trade (i.e. the value of exports in relation to the value of imports), which have been improving gradually since early 2013 when sterling first started to strengthen. A gradual process allows UK exporters to become more competitive through quality and productivity rather than focusing simply on price. A hike in interest rates would distort this and make exports artificially expensive thereby lessening the impact of any productivity improvements by widening the gap again.



Figure 2  |  UK terms of trade vs Euro per GBP, last price monthly, June 2001-August 2014
Source  |  DeltaMetrics 2014

Second, the sustained uncertainty around the global economy, European and Asian demand is affecting global trade. As Trade Views have noted successively, actual trade in 2014 is substantially below IMF expectations but, with the IMF and the OECD now reducing their forecasts for growth in 2014 and suggesting that Q4 may see a slowdown, it is likely that the manufacturing and export Purchasing Managers Indices (PMI) will suffer over the next 6 months. Our Trade Corridor Index – Sentiment (TCI-S) for the UK certainly suggests that the key PMI sentiment indicator is currently disproportionately high compared to export performance.

The correlation between changes in the Delta TCI-S and the PMI is over 70% and the flat outlook for UK trade is reflected in the TCI forecast; it is likely that the PMI will drop over the next few months reflecting the inherent weakness in underlying trade conditions and reducing the likelihood of a rate rise.




Figure 3  |  Delta TCI-S changes against changes in the PMI, June 2001-December 2016 (forecast)
Source  |  Delta Economics analysis

Third, the trade of key innovative exports sectors like cars and pharmaceutical products is highly correlated with the last price monthly value of sterling against the Euro (70% and 79% respectively). Both have been falling over the last few months as sterling has strengthened. Substantial policy effort has been put behind stimulating export growth in both of these sectors and particularly to China. Given that both are forecast to grow substantially over the next two years it is unlikely that the Bank of England will raise interest rates. This is because the effect of a rise in interest rates would be to strengthen sterling too far, too fast. This could potentially jeopardise any embryonic export-led growth outside of Europe.



 Figure 4  |  Value of UK exports of private cars to China (USDbn) vs Euro-GBP Last Price monthly, June 2001-August 2014
Source  |  DeltaMetrics 2014




Figure 5  |  Value of UK exports of medicines to China
Source  |  DeltaMetrics 2014

Fourth, trade is currently a drag on GDP. This is illustrated by the UK’s net trade openness: in other words the UK’s net exports as a proportion of GDP. The fact that this is falling means that the increases in GDP are forcing a rise in the deficit. This is creating the biggest drag on GDP since the financial crisis.



Figure 6  |  UK net exports as a proportion of GDP vs Euro per GBP, Last Price Monthly, June 2001-August 2014
Source  |  DeltaMetrics 2014

The disconnect between rising GDP and net exports has, as a consequence, created an asset bubble. The correlation between FTSE 100 and economic fundamentals trade has weakened since October 2011; the FTSE has risen while nominal trade values have been on a downward trend suggesting markets are no longer pricing in macro fundamentals such as trade. Disinflation, as evidenced by nominal export values and falling volumes (the forecast in current prices) means that this over-valuation is unsustainable. However, without a gradual correction, a rise in interest rates would exacerbate this detachment and pose the risk of a greater correction in Q4.



Figure 7  |  Value of UK exports (USDbn) vs FTSE 100 Last Price Monthly, June 2001- August 2015
Source  |  DeltaMetrics 2014

There are manifest reasons why a rise in interest rates is inadvisable in the current situation. In essence they boil down to the fact that national and global geo-political and economic uncertainties are too great to make a rise in interest rates probable in the next 9 months. A cynic might say that, in any case, there is a UK general election in 2015 and interest rates will not rise before then, but the weight of economic evidence suggests that there is no forecast pick up in the real economy or improvement in productivity. The economic problems remain the same and the process of building competitiveness through high value exports would be damaged by any increase in the value of sterling as a result of a rise in rates.


Lost interest?

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 hawkFinancial Times