Putting the Fright Into U.K. Banks and Bondholders

Includes: ERO, EU, EWU, FXE
by: Martin Fluck

If the UK’s banks don’t increase lending to small business, then the government is going to give them a serious kicking. At least so says Business Secretary Vince Cable, who will go on the “war path” and impose financial penalties such as an increase in the banking levy or taxes. However, because of political imperatives to increase inflation, Cable, like the Bank of England seems to be willfully misinterpreting the economic evidence, while the risk of higher interest rates grows.

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Rather like Cable, the Bank of England remains fixated on its quantitative easing program, even as inflation continues to rise in response to VAT hikes and inflation imported by the weakness of Sterling. Incredibly, Monetary Policy Committee member Adam Posen is now talking about “heavy-duty credit easing,” which would target specific sectors, as the US is (unsuccessfully) doing with the housing market – should its buying of government bonds prove ineffective in stimulating economic growth.

Talk about further quantitative easing, and increasing lending – even as inflation continues to pick up in the UK – probably reflects the coalitions desire to see the cost of government eaten away in real terms – given that it has frozen many budgets, and only given the NHS 2.5% annual increases – and a failure to understand that lending cannot be nor should be restored to the levels that were seen in the credit bubble.

Companies and individuals need to save more now rather than borrow. That is why small companies may be cutting their borrowing rather than struggling to access credit, as Cable thinks, and why mortgage lending is down and the housing market is weakening. Mortgage approvals for house purchases by the UK’s major lenders fell to a 16-month low of 45,000 in August from 47,000 in July, a bigger-than-expected fall. And gross mortgage lending reported by the Council of Mortgage Lenders fell to £11.4bn in August, from £13.3bn in July, the lowest level for the month of August in a decade.

Extending the Bank of England’s £200bn quantitative easing program because of faltering money supply growth – which fell to the 1.8% August, the lowest level since the series began – would be like “pushing on a piece of string” – as has the Fed’s own program has been likened to – and only store up potential inflationary trouble for the future.

There are risks, says Bank of America Merrill Lynch in its latest economics report, of interest rates rising notably faster than current market expectations. Using its Taylor Rule estimates (see chart), it calculates there’s a 25% chance of interest rates rising to 3% or more by early 2012: “Interest rates rising that fast is by no means our central projection, but with the level of GDP in the UK currently around 4.5% below its peak in early 2008, such risks may be underappreciated.”

Moody’s (NYSE:MCO), which has endorsed the UK’s austerity plans, thinks that the UK “appears sufficiently flexible and robust to grow, even in the face of austere fiscal consolidation.” Challenges remain, from “private sector deleveraging, the uncertain state of the financial sector and slower growth in the UK’s main trading partners,” but if a moderate pace of growth is maintained, the primary budget balance will be in surplus by around 2014.

GDP growth will continue to remain above trend, and private sector output should rise slightly faster, agrees Lombard Street Research. This is because exporters are continuing to do well, as the weak pound finally makes its impact felt. As expected new orders are some way above ‘normal’, the rebound in industrial activity may indeed be based on a more fundamental shift in the demand for UK exports.

A net balance of 12% of manufacturers are expected to raise output over the next three months, according to the latest Industrial Trends Survey, compared with a long-run average of 7%. Only 4% reported that current inventories were sufficient given expected demand, so they are restocking.

For the time being, the Bank of England maintains that the 3.1% rate of inflation is not being passed through to general rises in inflation, as it is only due to temporary factors like Sterling’s decline, and because growth is likely to weaken. But the Bank of England’s forecasting record is, though, no better than your guess or mine.

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“The events of the last three years provide ample evidence of the benefits of considering the whole distribution of risks: perhaps particularly those far away from central expectations,” says Bank of America Merrill Lynch. In due course, the MPC’s central forecasts from its August Inflation Report (.pdf) could be consistent with interest rates rising notably faster than current market expectations through 2012 and 2013.

So the real question is how long it will be before the market realizes that the probability of further quantitative easing is slim, and responds to the rising inflation by forces up yields on UK government debt.

Disclosure: No positions