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United Kingdom, but the problems are the same | 22nd September 2014

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.

 

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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.

 

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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.

 

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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.

 

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 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

 

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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.

 

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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.

 

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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.