The much improved confidence levels of market participants took a bit of
a hit this past week, as the sectarian conflict in the Middle East
flared up in Iraq and UK's BoE governor Mark Carney hinted that it may
be necessary to raise rates earlier than markets currently anticipate.
Stock markets across Europe dropped as a result, but it was clearly the
UK which gave back the most gains, losing up to 1% on Friday, following
Mr Carney's speech at the annual Mansion House gathering
Carney surprised markets with his remarks and they reacted accordingly: Sterling gained versus other currencies, while bonds and equities fell as yields rose across the maturity spectrum. Higher yields make credit finance more expensive and can thereby reduce the growth prospects. This can be desirable when the economy is at the risk of overheating, but at the moment we are still far from it. However, in the aftermath of the financial crisis, interest rates are still at such exceptionally low levels that we are witnessing various negative side effects, which could themselves become economic issues further down the line. UK house price rises on the back of low mortgage rates and a shortage of homes is one such example, the general tendency for assets to become overvalued is another. Here government and corporate bond prices can be identified. Raising rates would counteract these undesirable side effects, but at the same time they risk choking off the recovery which is only just getting properly started.
I believe Carney's surprising and sudden change to his previous forward guidance is that he is quite possibly trying to adopt Mario Draghi's (ECB) approach of threatening the markets with some penalising action, which then becomes unnecessary, because markets react in the desired direction as if the penal action had been taken. Draghi's 'whatever it takes' pledge for keeping the Eurozone afloat was the most successful example for this strategy: The ECB never had to intervene, because market participants stopped to speculate with a break-up. Carney's warning had a similar effect – yields which are deemed too low at the moment (see previous issues of our Weekly) promptly rose, thereby delivering a cooling effect for the asset price inflation catalysts. So, by threatening an earlier first rate rise he has the potential to actually prevent such action, if yields rise enough to dampen the mentioned negative side effects, then interest rates can possibly remain low in support of the ongoing economic recovery. In any event it is good to see that our Bank of England leadership is determined to take action, rather than let things fester. History and experience shows that it is the unaddressed and surprise issues that derail economic progress – once risks have been identified and are addressed they rarely deteriorate further. This is as much true in the UK and the Eurozone, as it is in faraway places like China, whose government is equally tackling misallocation of capital.
The new troubles in Iraq are caused by Sunni Muslims overrunning numerous cities in the oil rich North in an attempt to regain influence from the now governing Shia Muslims. What at first hand appears as a localised conflict in Iraq which has been ravaged by civil conflicts ever since the US led overthrow of Saddam Hussein, has in reality the same roots as the Syrian civil war, which is the centuries old animosities between the Sunni and Shia Muslims. This latest unrest is further destabilising an already deeply troubled region and it is therefore not surprising that oil prices increased on the surprise news. This could potentially be a set back to the European growth prospects, which has a higher dependency on the Middle East's oil than the US. However, given the oil exploration in Iraq's North is not particularly meaningful, the overall impact was less pronounced than one might expected. Regardless, the renewed increase in economic outlook uncertainty should be sufficient to prevent European equity markets from becoming too exuberant and overshoot on the otherwise strengthening growth prospects
For more stories, visit: www.kassiusannuities.co.uk
Carney surprised markets with his remarks and they reacted accordingly: Sterling gained versus other currencies, while bonds and equities fell as yields rose across the maturity spectrum. Higher yields make credit finance more expensive and can thereby reduce the growth prospects. This can be desirable when the economy is at the risk of overheating, but at the moment we are still far from it. However, in the aftermath of the financial crisis, interest rates are still at such exceptionally low levels that we are witnessing various negative side effects, which could themselves become economic issues further down the line. UK house price rises on the back of low mortgage rates and a shortage of homes is one such example, the general tendency for assets to become overvalued is another. Here government and corporate bond prices can be identified. Raising rates would counteract these undesirable side effects, but at the same time they risk choking off the recovery which is only just getting properly started.
I believe Carney's surprising and sudden change to his previous forward guidance is that he is quite possibly trying to adopt Mario Draghi's (ECB) approach of threatening the markets with some penalising action, which then becomes unnecessary, because markets react in the desired direction as if the penal action had been taken. Draghi's 'whatever it takes' pledge for keeping the Eurozone afloat was the most successful example for this strategy: The ECB never had to intervene, because market participants stopped to speculate with a break-up. Carney's warning had a similar effect – yields which are deemed too low at the moment (see previous issues of our Weekly) promptly rose, thereby delivering a cooling effect for the asset price inflation catalysts. So, by threatening an earlier first rate rise he has the potential to actually prevent such action, if yields rise enough to dampen the mentioned negative side effects, then interest rates can possibly remain low in support of the ongoing economic recovery. In any event it is good to see that our Bank of England leadership is determined to take action, rather than let things fester. History and experience shows that it is the unaddressed and surprise issues that derail economic progress – once risks have been identified and are addressed they rarely deteriorate further. This is as much true in the UK and the Eurozone, as it is in faraway places like China, whose government is equally tackling misallocation of capital.
The new troubles in Iraq are caused by Sunni Muslims overrunning numerous cities in the oil rich North in an attempt to regain influence from the now governing Shia Muslims. What at first hand appears as a localised conflict in Iraq which has been ravaged by civil conflicts ever since the US led overthrow of Saddam Hussein, has in reality the same roots as the Syrian civil war, which is the centuries old animosities between the Sunni and Shia Muslims. This latest unrest is further destabilising an already deeply troubled region and it is therefore not surprising that oil prices increased on the surprise news. This could potentially be a set back to the European growth prospects, which has a higher dependency on the Middle East's oil than the US. However, given the oil exploration in Iraq's North is not particularly meaningful, the overall impact was less pronounced than one might expected. Regardless, the renewed increase in economic outlook uncertainty should be sufficient to prevent European equity markets from becoming too exuberant and overshoot on the otherwise strengthening growth prospects
For more stories, visit: www.kassiusannuities.co.uk
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