Forward guidance: Is it too early for a requiem?

We have written recently on the increasing likelihood of a rise in UK interest rates coming sooner rather than later despite the “guidance” offered by the UKs top Central Banker, Canadian Mark Varney.

Our proposition is based on the premise that the UK economy will recover more strongly through late 2013 and 2014 than the Bank of England is currently forecasting. That recovery would be augmented by a continuing rise in UK house prices, fanned by London & the Southeast and the gradual relaxation of strict lending criteria by the high street banks. Indeed just last week the influential “think tank” OECD said pretty much that –

“UK growth would accelerate in the second half of the year (2013), with the economy expanding by 1.7 per cent between June and December. “  Furthermore, “If that pace of expansion continues into 2014, Britain’s recovery would begin to resemble a normal upswing rather than the slowest recovery from recession that it has endured since 2010.”

Of course we will only know if we are to be proved right in our assertions on UK interest rates with the benefit of the passage of time but that is what we are paid to do – forecast the future.

The current situation between “market rate” expectations and Carney & the BoE’s words has set us wondering about the entire viability & benefits of Forward Guidance as a policy tool and, it seems we are not alone in doing so. Indeed there have been doubters about the effectiveness of the policy right from the word go.

The idea behind Forward Guidance is laudable as it aims to turn monetary policy from a narrow target driven tool into one with a much more holistic approach that looks at the economy as whole rather than series of specific indicators. It also seeks to bring an end to the semantic analysis of policy announcements, where every nunance, phrase and syllable, whether written or verbal, emanating from the Central Bank is endlessly dissected in search of some hidden meaning. Howeve,r as the Respected Goldman Sachs Economist Jim O’Neill wrote in the Daily Telegraph on the 16th of August

“The success of the “forward guidance” policy hangs on the assumption that the central bank actually has a greater ability at forecasting the future than the collective capacity of the global markets. It also assumes that the UK’s own markets, especially for bonds and currency, are insulated from events elsewhere.”

Many would argue that the Bank of England does not possess any special insight into the UK and global economies in an age of big data, surveys, social media and instant feedback. Indeed given the resources available to the global markets as whole it would be incongruous if the BOE did have an “edge”. Certainly “Merv the Swerve” proved himself practically useless at forecasting the future of the economy, in fact he was an advocate of more QE only several weeks before his departure. What a mistake that would have been. As for Andrew Sentance, don’t get me started!

Although the UK economy is certainly not insulated from the global macro background, not least because of the interconnected nature of modern capital markets, it is fair to say that our retention of an independent currency has, to date, spared us from the worst excesses of the post credit crunch “fall out” as suffered by Spain Greece and Ireland for example.

The Bank of England under Mr Carney has chosen to nominate a rate of unemployment of 7% or under as a potential trigger point for a UK rate rise. At the same time Mr Carney suggested that in his view UK rates would likely remain unchanged for up to two years. These statements might well come to be viewed as just a Central Bankers wish list, rather than a concrete forecast for the future direction of the UK economy. He seems not to be familiar with the saying “events, dear boy, events”. And I rather suspect that he will become familiar with this in subsequent months…

Forward Guidance has in fact been employed for longer periods in other major economies – most notably in the US, and we can look at their experience for clues as to what we can expect in our own future. US Banking giant Bank of America Merrill Lynch has recently looked at the historical impact and effectiveness of the US Federal Reserve’s implantation of Forward Guidance, as registered by the US Bond markets and in particular the five and ten year papers.

More specifically BOA looked at the volatility seen in both the five and ten year bonds and the ratio between them (on the basis that forward guidance, if effective at all, would work over the short to medium term and  would not directly affect the long dated end of the curve) – the so called 5-10’s spread.

As we can see from the BOA chart below Volatility in the medium term bond market was significantly reduced by the introduction of a zero interest rate policy or ZIRP and that volatility was for the most part contained by the introduction of Forward Guidance in 2011. However, it would appear that following comments from Mr Bernanke earlier in summer about an impending taper,   the genie is once again out of the bottle and it will now prove to be extremely difficult to recapture.

What has happened in effect, is that there has been a disconnect between what the market believes will happen and what Mr Bernanke and the other members of the FOMC would like to happen.

This disconnect has likely been strengthened by comments that followed Mr Bernanke’s “tapering speech” which sought to play down his prior comments, and which in turn has raised questions about the credibility of and conviction in the Federal Reserve’s guidance going forward. That disconnection can clearly be seen in the chart below which plots the yield on the US Ten Year Bond.

The yield here has risen sharply since May this year and despite pausing for breath, has not yet shown that it has run out of steam.

I also note that the chart of the UK tend year Gilt yield looks remarkably similar (see chart below) and though you would expect changes in major benchmark bond yields to be closely correlated, the final chart (which plots the 10 year Gilt yield alongside the GBP/US exchange FX rate), to my mind, clearly illustrates that the markets belief that sterling interest rates will rise in the near term is independent of movements in the US. Hence the strengthening of GBP / US$ (something we were a lone voice in forecasting) and the 10 year Gilt yield since Mr Carney took control at the Bank of England in July.

We remain positioned to take advantage of a rise in inflation and an attendant re-rating of the pound in our flagship Titan Global Macro fund and with the look of the chart below expect cable to rise over $1.60 in the comng months – thankfully currently a relatively lone expectation and one in which we thus find comfort and have a high conviction in its playing out.

R Jennings, CFA. Titan Investment Partners.