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The press had made much of the Bank of England’s (BoE) meeting with City economists yesterday, speculating about what important announcement was to be made. In the event, the meeting was significant but only because of the hype that preceded it. “BoE won’t alter deposit rate soon”, screams the Wall Street Journal, “BoE has no plan to lower rate on reserves”, says the Telegraph (click here) and “Pound up as fears of Bank rate change ease”, is The Times headline (click here). In other words, the meeting was a damp squib but heightened expectations ahead of it led to a reaction in currency and interest rate markets. An upbeat CBI Distributive Trades survey alongside the sharpest rise in UK consumer confidence since 1995, and all of a sudden the mood is more optimistic. Except in Brighton, where the Labour party have to live without the support of the Sun newspaper.

The MPC seems set now on waiting for the September and early October economic data to be released and reviewing their position in the November MPC meeting, just before the publication of the next Inflation Report. The question they must answer is whether the steps already taken will start to work, with a lag, and that is what they will try and fathom from the data. Meanwhile the domestic economy is being helped – in my opinion – by the weather. I am approaching the end of my first month working at ECU and my view is heavily biased by the shift from dreary Bishopsgate to the West End. However a glorious Indian summer has brought the crowds to Oxford Street. I am not surprised retailers are slightly less depressed than they were a couple of months ago when ‘staycationing’ Brits were leafing through brochures planning a holiday in the sun for the summer of 2010.

The other piece of economic news to emerge yesterday was detailed UK Q2 GDP data. This posted a small revision from -0.7% to -0.6%, but I was more interested in the fact that the second quarter saw UK households run a financial surplus (i.e., became net lenders) for the first time in eight years (click here). This is important. A rising savings rate (i.e., a decreased borrowing rate) is a natural impact of a recession. However, the UK is going a bit further now. Real household disposable income is growing, but spending has remained depressed so the household sector – like the corporate sector – is repaying debt and becoming a net lender. We have spent so long being net borrowers in the UK that this process has further to run but it is much easier for a recovery in confidence (which we are seeing) to turn into a recovery in demand when there is money to support the spending.

It would be wrong to see the recent moves in market interest rates as a purely UK affair. Since the MPC first brought up the idea of finding additional ways to ease monetary policy in August, money market rates have fallen in the US and Europe as well. Central bankers have been united in saying that they are uncertain about the durability of recovery and in promising to keep rates as low as necessary for as long as necessary. This chorus of policy accommodation helped equity and precious metal prices and, as market interest rates converged towards zero, the strongest major currency was the yen. Because they have long been mired in deflation and have no room to cut rates further, lower global rates mean those elsewhere fall relative to those in Japan. The comments from Kevin Warsh I referred to last Friday (click here) and the better tone to economic data generally (we even saw a 20,000 fall in unemployment in Germany in data released this morning) are causing a bit of a hedging of interest rate exposure in markets. The UK was the catalyst for lower market rates and seems to be a catalyst for higher ones now. No G7 central bank is set to raise rates soon and we have seen cuts in Hungary and Russia recently but Australia and Norway are very likely to hike before Christmas. And if we have seen the low point in market rates in the UK, US and Europe, the yen’s current strength will not persist.

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A range of countries has been releasing consumer price inflation data in the last couple of days and they have one thing in common: inflation is falling and mostly negative. Germany’s September CPI came in at -0.3%, Spain’s CPI at -1% but it is Japan’s inflation that is truly alarming at -2% in September for the city of Tokyo, -1.4% excluding the volatile food and energy component. That is the deepest deflation since 2001. In other economies, the current falling prices are likely to be reversed when very sharp monthly falls in the fourth quarter of 2008 fall out of the year-over-year comparison. Germany’s six-month annualised inflation rate is still (just) positive. But in Japan, we are seeing a full-scale return to deflation. The Times gives an interesting analysis (click here).

A wise friend told me years ago that he couldn’t understand how Japan could be mired in deflation and suggested that if they wanted help, they call him up at his office in Buenos Aires. The authorities in Argentina have struggled time and time again with inflation and would be able to solve deflation in a flash. I have long had some sympathy for the view. If you are in a deflationary spiral where demand is collapsing and people are hoarding cash, you should boost the amount of money in the economy and devalue your currency. In fact, you should do what the UK and the US have been doing this year. The very last thing you should contemplate doing is to talk up your currency, as the new Japanese Finance Minister appeared to do last week. This is madness. Mr Fujii has been quick to pour cold water on his remarks, but the yen remains strong. To my mind, Japan has a greater need to prevent currency appreciation than any other major central bank and will be the last to contemplate any form of monetary tightening.  

The ECB President, Jean-Claude Trichet, followed Mr Fujii in talking about currencies yesterday. He warned that a strong dollar is ‘extremely important’ for the world economy at the same time as reiterating that now is not the time to remove emergency stimulus measures. This I take to be a response to the talk of global re-balancing that emanated from the G20 meeting. It is inconceivable that global imbalances can be reduced significantly without the dollar falling, but the German and Japanese authorities will be keen to ensure that the upward currency adjustment is made by high-surplus emerging economies more than G7 ones mired in deflation. For markets, it’s a reminder that interest rates will stay low for the conceivable future and increases the focus on those economies where monetary policy will be tightened first. The Norwegian and Australian central banks are both seemingly set on raising rates this year and their currencies are set to out-perform for a while. The only difference now is that their currencies look set to rise against the euro and yen as well as the dollar.

In the UK, this morning sees a much-publicised meeting between the Bank of England (BoE) and City Economists and also the release of final August money supply data. I have reviewed the sectoral breakdown to the money data which gets little market attention but is critical to a return to ‘banking as usual’ (click here). Lending to the household sector held steady at £900m but lending to the corporate sector rebounded after July’s fall. Overall, there are glimmers of life but nothing more. Meanwhile, mortgage lending increased by £1.001bn, and mortgage applications came in at 52,317. For the BoE, the question is whether the measures taken to date will lead to increased lending. If the September data do not show signs of improvement, Mr King will surely push for more quantitative easing and a cut in the rate that the BoEpays for banks’ reserves in November at the latest.

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The main focus in financial markets of late has not really been on the direction of the global economy. The recovery continues but doubts remain as to the sustainability of that recovery and these doubts are going to stay with us for some time. Rather, the focus is on policy-makers. In the US, the Fed’s policy of very low rates and a plentiful supply of liquidity to the financial system are behind the rally in equity and commodity markets and the US dollar has weakened steadily. But an article I mentioned in this blog on Friday by Kevin Warsh, Federal Reserve Governor, has attracted huge debate. Is Mr Warsh signalling that the Fed is going to take away its monetary stimulus earlier than anyone expects? Over in Japan, a new government was not expected to signal any major policy changes but the Ministry of Finance (MoF) appeared to be more willing to tolerate a strong yen than its predecessor. And in the UK, although economic data point to recovery, Mervyn King has voted for increased quantitative easing and appears warm to the idea of a cut in the rate the Bank of England (BoE) pays banks for their reserves. He has also welcomed the pound’s fall.

Mr Warsh has put a speed bump – at the very least – in the way of global equity markets. And the dollar has fallen over the last month against all the major currencies with the exception of the Canadian dollar and sterling. The MoF officials’ change of tune has seen the yen out-perform all the other major currencies since the election and Mr King has helped ensure that sterling has been – by some distance – the worst performer.

In the UK, the BoEappears to be trying to calm sentiment or, at least, point out that Mr King said the fall in sterling’s value to date has been helpful rather than welcome a further decline. The Sunday Times provided a couple of interesting takes on sterling written by David Smith (click here and here). I am not sure whether this means the Bank are uncomfortable with sterling’s latest fall (surely Mr King knew how the markets would react). However, I am sure that a further fall in sterling’s value would be unhelpful. The front page of the FT carries a story highlighting my greatest concern (click here). The UK will have the highest inflation rate in the G7 this year and next. Letting the pound slide too far (let alone encouraging its descent) will make that much worse and create a huge headache for the MPC down the road. At the moment, the MPC is overwhelmingly concerned about getting credit flowing around the economy but as soon as that starts to change, the focus of policy will too. I think there is still a very strong chance that the MPC will be the first of the major central banks to raise rates in 2010. I think sterling will bounce before then, probably as soon as we see signs of life in bank lending data. That has not happened yet though early indicators show that September has been a better month for retailers.  

In Japan, the Finance Minister, Mr Fujii, took advantage of a Bloomberg-hosted forum to say that he “never said I will leave the yen to strengthen”. He re-iterated the usual line about FX stability. Japanese consumer price inflation data are due overnight and are expected to show deflation deepening as CPI falls 2% in the year to September. Why would any country with that degree of deflation want an even stronger currency?

The US equity rally was due a pull-back and Mr Warsh has helped trigger one. My core views of the US have not changed in September and early economic data for the month show a further rise in consumer confidence, a fall in weekly unemployment claims and strength in regional manufacturing confidence. The all-important monthly payroll report is due on Friday. I expect it to show a further decline in the pace of job losses, i.e., unemployment is still going up but at a slowing rate. It is all well and good for Mr Warsh to warn that policy will be tightened before indicators such as employment have turned but in practice that is unrealistic. Alone among the major central banks, the Fed has to juggle an inflation target and an employment target – low and stable inflation subject to full employment. I am sure Mr Warsh does not want markets to perceive Fed policy as a ‘free ride’ but I am equally sure that rates will not be raised until recovery has far more solid foundations. The next couple of months will see asset gains harder to come by, but stocks look likely to end the year above current levels. As for the dollar, it is in a secular downtrend as increased supply, low yields and global economic re-balancing will all weigh on it for a long time.

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The G20 meeting in Pittsburgh will spend today talking about reform of bank regulation and bankers’ bonuses. Yesterday’s big news item was that the G20 is increasingly set to replace the G8 as the main body for overseeing the global economy. There will be more peer review of members’ policies and a shift in IMF voting in favour of the emerging economies. There is also a rather bland commitment to boost global re-balancing by reducing dependency on US consumers, encouraging China to boost demand and Europe to boost investment. The shift from G8 to G20 will make meetings more unwieldy but does simply reflect the new economic reality that the G8 club is getting less and less representative of the global economy. There almost certainly won’t be anything as unsubtle as mention of currency levels in the final communiqué, but global economic re-balancing cannot happen without cutting the US trade deficit and reducing the big Asian surpluses. That, in turn, is hard to envisage without further dollar weakness over the medium term.

As we move past the G20 meeting, the focus will shift to whether the last two days’ falls in the US equity market are anything more than a temporary speed bump. Market technicians point to unhelpful chart patterns and star-gazers like to look for trends to turn around after the Autumn Equinox. I have always preferred more fundamental drivers for markets, but the way the equity market traded after the US FOMC meeting suggests that the rally had become stretched. That justifies a speed bump and perhaps more weakness for a few days. However, the driver of the rally in asset markets is the commitment of the US authorities to keep policy accommodative and do everything they can to ensure recovery. Kevin Warsh, one of the Fed Governors, wrote an article in the Wall Street Journal overnight outlining marginally more hawkish views than those we hear from Ben Bernanke (click here). I think it’s clear there is some division within the FOMC about when to start taking back policy accommodation, but the key observation in this piece is that the Fed’s battle against the unprecedented economic crisis is not yet won. I cannot imagine a consensus building at the FOMC to start withdrawing stimulus until there is conviction that this battle has been successfully concluded. The next few months will continue to see benign inflation trends so the Fed won’t feel any excuse to act. That ensures that asset-friendly policies remain in pace and dollar weakness will not be a source of any concern.

In the UK, the pound’s dramatic slide yesterday is a major source of attention, and Bank of England (BoE) Governor Mervyn King’s comments in Newcastle also got attention. The Telegraph’s interpretation is of interest (click here) but also worth noting is an article that appeared on the Reuters newswire yesterday evening quoting a speech by BoE Chief Economist Spencer Dale (click here). Dale is slightly more upbeat in his comments than the Governor. There is no reason to believe that the pound’s weakness is causing any loss of sleep at the BoE, though I wonder how Mr King feels about the latest slide. The UK will have the highest inflation rate in the G7 next year again, and a falling pound exacerbates that problem and removes degrees of freedom on interest rate policy. At the moment, markets are vulnerable to every utterance by Mr King and it is clear that – like the Federal Reserve – the MPC is going to do everything it has to in order to give recovery a chance to become self-sustaining. However, once evidence of recovery does appear in lending data, the MPC is likely to be among the quickest of the major central banks to contemplate increasing rates and, if this happens, sterling will look very cheap.

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The US FOMC left interest rate policy unchanged yesterday. The statement that accompanied the decision (click here) acknowledges the pick-up in economic activity over the summer, makes minor changes to the policy language and announces that purchases of mortgage-backed securities will taper off from here. Financial markets initially reacted to the general dovish tone, buying stocks and selling the dollar but that move quickly ran out of steam. I take two lessons to heart from the FOMC and the market response. The first is that the Federal Reserve, like the UK MPC and other central banks, is committed to keeping policy accommodative until there are really clear signs that economic recovery is self-sustaining. The second is that this theme is now much more widely embraced in markets than when I arrived at ECU three weeks ago (the S&P index is up 6.5% over those three weeks) and that opens the way for short-term corrections.

The IMF is slowly drip-feeding its October World Economic Outlook onto its website. They are up to chapter 4 (click here). It is interesting because it provides a very detailed discussion of the medium-term prospects for the global economy after a recession that followed a financial crisis. The conclusion is that after this type of recession/crisis, the path of output tends to be depressed substantially and persistently. I think this analysis, shared by policy-makers everywhere, is very influential at the moment. Policy-makers, having spectacularly failed to see the crisis coming, are surprised by the strength of the rebound but extremely wary of the medium term. Their analysis tells them that growth will bounce but not take off. And consequently that inflation is not a threat. In that environment, the dangers of prematurely removing policy stimulus far outweigh the dangers of keeping rates too low for a long time or of creating new asset bubbles. So despite stronger growth, rates stay low and there is no concern at all within the Fed or the US Administration about the dangers of a weaker dollar.

Ben Bernanke at the Federal Reserve clearly thinks this way. And so too does Mervyn King at the UK MPC. But Mr King takes it one step further. Yesterday’s MPC minutes were greeted with buying of sterling and selling of gilts in the belief that further accommodation is less likely. As I suggested yesterday however, Mr King voting with the consensus on September does not prevent a further move to help kick-start bank lending in November when the next Inflation Report is due. This morning Mr King is quoted in the Newcastle Journal saying that the fall in the exchange rate will be helpful in rebalancing the UK economy to help reduce the trade deficit. You could point out that this was aimed at an audience in a manufacturing area who want to hear that exports are more important to the UK’s future than overpaid bankers, but Mr King is a very old hand at this game. He will have known that newswires would pick up his comments. I believe Mervyn King is much less worried about the inflationary impact of a weak pound than he is about the threats posed to recovery from a weakened finance industry. This view will change – probably dramatically – when the UK is back on a sustainable growth path and when bank lending is clearly picking up. When that happens, UK monetary policy priorities will shift and sterling will recover sharply. But in the meantime, pro-growth and pro-reflation policies remain in place.

There is little new economic data out today. The US sees weekly unemployment claims data and August New Home Sales which probably recovered slightly from 5.24m to 5.35m. Many of these will be sales by banks of re-possessed homes. In Europe we saw the German IFO business climate indicator which correlates very well with European GDP growth. It has risen sharply in recent months but in September the rise was smaller than economists expected to 91.3 from 90.5. The recovery continues but at a slightly more moderate pace this month – which will play straight to central bankers’ fears about the medium-term growth path.

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The economic recovery is continuing in September, though in Europe there are tentative signs that it is losing a little momentum. Markit Economics released the ‘flash’ European composite PMI index of activity today for September, the first of the major indicators for the month. It came in at 50.8 – up from 50.4 – and is back at levels last seen in mid-2008. A reading above 50 indicates growth, so this is positive news, but the rise was less than expected and a lot smaller than the increase in recent months. This plays very much to the belief among policymakers that while the second half of 2009 will see a significant bounce in growth, the recovery may falter in 2010. Central banks and Finance Ministers have been very consistent in this regard. They worry that the need to reduce indebtedness in the household and corporate sectors will mean that the recovery does not become self-sustaining once fiscal policy is tightened. And that fear is driving policy-makers’ behaviour.

In the UK, this concern about the lack of follow-through for recovery was the backdrop to the MPC meeting two weeks ago, the minutes from which were released this morning (click here). The meeting saw Mervyn King and David Miles back down from their vote for a further increase in the Bank of England’s asset purchase programme. On the surface, this seems a change of tone form the Governor’s testimony to the treasury and Civil Service Select Committee. However, with data also showing weakness in consumer credit and in mortgage approvals in August, the MPC’s underlying worries about their inability to get credit flowing around the economy remain. I strongly suspect that the MPC will re-visit the notion of further quantitative easing as well as a cut in the rate that is paid for banks’ reserves at the October and November MPC meetings.

The US FOMC announces the outcome of its policy meeting this evening and there is some concern that they too will indicate that they will be reducing the amount of liquidity they pump into the financial system. With the Bank of Canada announcing last night that they will allow two temporary liquidity facilities to expire at the end of October, there is a bit of a trend for central banks to ease back a little on the pace of money-printing. It is possible that this will provide some temporary relief for the US dollar. However, the commitment to keeping both policy rates and more importantly market interest rates at exceptionally low levels seems intact to me. And as long as that is the case, I think the underlying reflation story will remain intact. That implies higher equity indices, stronger commodity prices, stronger growth in Asian economies and a weaker US dollar.

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The Bank of England’s (BoE) Quarterly Bulletin is a relatively dry document and has become less important for financial markets since the introduction of the Inflation Report. However, yesterday’s publication contained an article entitled Interpreting Recent Movements in Sterling (click here if you need help getting to sleep). The sting was in the tail, with the conclusion that, “it is also possible that sterling’s depreciation may be part of a more prolonged process of rebalancing of the UK economy, generating a fall in the long-run sustainable real exchange rate, although it is again difficult to obtain direct evidence about this possibility”.

That the press made a big deal of this story and markets reacted to it with sterling falling on Monday, tells us a lot about the nervousness surrounding sterling at present. It is possible to conclude that the BoE welcomes a softer currency – otherwise why would they include any analysis of the currency in the Bulletin? However, it is more likely that a rather dry economic analysis of sterling’s decline was considered relevant and topical and we should read nothing into it. That sterling’s long-run equilibrium may conceivably have fallen is interesting but irrelevant bearing in mind how much the pound has fallen in the last year. This move strikes me as typical of the final flurry of selling that accompanies the end of a trend and I suspect that sterling is therefore close to its lowest levels for the year against both the US dollar and the euro. There are still obstacles, given that MPC members and Mervyn King in particular remain very concerned about the weakness of consumer and corporate lending. Measures have been taken to boost lending and further measures still seem likely in the form of increased bond purchases by the BoE and possibly a cut in the rate the BoE pays for reserves. However, these actions are now priced into the long-term interest rate structure in the UK. We will find out tomorrow (September 23rd) what the minutes of the last MPC meeting tell us about the state of policy deliberations, but market participants are now braced for dovish comments.

The G20 meeting in Pittsburgh continues to attract considerable attention. Equity markets retreated yesterday and the dollar rallied while the price of gold dipped. As I wrote yesterday, my own expectation is that we should expect little in the way of concrete policy action, but a pro-growth tone and a verbal commitment to try and reduce global imbalances. That combination is good for reflation and bad, at the margin, for the dollar. Overnight press commentary has speculated about G20 talking about ways to re-balance growth by talking down the dollar, which is consequently weaker this morning across the board. Commodity-related currencies look set to remain very much in demand and equity markets may receive a boost after a very small correction. And Government bond markets, with very little economic data to react to, will brace themselves for the auction over the next three days of $112bn in 2-, 5- and 7-year debt. That is a tidal wave of debt for the market to absorb and will demand a yield concession. The question is whether the 19bp rise in 5-year yields we have seen so far this month is sufficient.

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Leaders of the G20 group of nations meet this week (September 23rd/24th) in Pittsburgh. The backdrop to the meeting could be interpreted as encouraging, with the global recession ending as growth returns everywhere. However, it seems clear that the temptation to pat each other on the back for a job well done in fighting the worst economic downturn since the 1930s will be resisted. A number of themes seem set to dominate discussions.

The first is the risk of economic recovery proving unsustainable and overly reliant on short-term policy measures. I am stunned by the volume of warnings that signs of economic recovery should not be interpreted as an ‘all clear’. The global economy is heading for a growth rate next year which could well exceed 4%, and all the available data demonstrates that recovery is as synchronised as the downturn was – in contrast to talk of de-coupling. There is no doubt that a slower pace of de-stocking and a recovery in demand due to fiscal accommodation are major drivers of the recovery and are not, of themselves, self-sustaining. It is also true that unless there is strong enough growth to generate a rebound in employment, then the recovery will fall flat on its face. And finally, it is true that we will not be able to simply borrow our way back to previous levels of consumption in the US (and UK). For all of these reasons, it is desirable to make sure that policy remains extremely accommodative for some time to come and that this accommodation is only removed when there are signs that recovery is self-sustaining. But to argue that the recovery is doomed because it hasn’t generated employment in its very earliest stages is ridiculous and to sound excessively pessimistic seems unwise. What I learn is that policymakers, having spectacularly missed the recession, are likely to miss the recovery as well and ensure that policy is too easy for too long. That does, at least, provide some comfort to me that next year’s growth risks are tilted to the upside.

The second theme will be reform of the banking system. Bankers’ bonuses make the headlines but it is how banks are regulated which will matter more. They will need more capital going forwards and they will likely be smaller. This makes good economic sense. The banking industry consolidated for two reasons; the first was to save costs and the second to diversify the risk profile of banks away from single regions and industries. A bank which is based in a mining town only lends to miners and is doomed to follow the cycle of that industry. However, what we have found in this cycle is that the global economy is much more diversified than most realised. A big bank therefore does not have the diversity of income to escape the cycle – only the illusion that its risks might be uncorrelated. And that illusion is what undid the structured credit market in 2008.

The third topic will be how to re-engineer global financial architecture. For some time, the world has worked on the basis that Europe sells machine tools to companies in Asia, who use them to make consumer goods which are exported to the US where they are bought it seems with cheap credit. This model is obviously dependent on ever-rising US debt levels and on the illusion that massive global payments imbalances are sustainable. G20 will discuss how to change things. A shift away from the dollar as a global reserve currency will be one topic and the price of gold – after a temporary dip – will likely rise again. Ways of boosting demand in Asia will be discussed too, though Asia is already doing just about everything it can. And the US doubtless would welcome a slightly weaker dollar too – though I cannot see any benefit to the Asian economies of stronger currencies at this stage.

It would be wrong to expect concrete action this week from G20. But the tone ensures that policy-makers remain supportive of growth. Rates are likely to stay lower for longer and fiscal tightening is pushed back. To my thinking, that increases the chance of this recovery having legs and is certainly good for asset reflation. It is good too for gold and hard currency proxies but the debate about global re-balancing can only be bad for the dollar in the longer term.

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The US Treasury bond market wobbled on Wednesday but it bounced right back last night. You could have been forgiven for thinking that a string of stronger economic data releases was finally causing investors to shun the feeble yields available on Treasuries (a 2-year Treasury yields just 0.95%, a 10-year Treasury 3.39%). But the August Housing Starts data, which showed starts rising overall, was let down by a fall in single-home houses. In other words, strength is in the very volatile condominium category. The much-watched Philadelphia Fed manufacturing activity survey saw general business activity rise, but orders slowed and employment and inventories fell. Fear that any economic rebound will prove temporary is deep-seated and it is increasingly apparent that central bankers need to keep the monetary tap wide open and will welcome higher asset prices if that is the upshot. A recovery in US equity wealth compensates for the collapse in housing wealth, helps banks’ asset portfolios and slows the pace of household balance sheet reduction.

The main talking point this morning is an article in the Daily Telegraph saying that the FSA has dashed Lloyds Bank’s hopes of avoiding participation in the UK Government’s Asset Protection Scheme because the bank has insufficient capital (click here). This story was doing the rounds in the US yesterday evening and has caused a further loss of confidence in sterling and the UK economy. My own view is that there is no new information here. The improving environment is helping the British banks make money on a day to day basis, but the legacy of past bad lending is still there and needs to be resolved. This will take a long time but will be significantly helped by asset price inflation and low interest rates. Consequently, it makes no sense to look for the FSA to let any of the banks ‘off the hook’ yet but it does make sense to expect the Bank of England (BoE) to persist with a very aggressive policy of low rates, quantitative easing and a cut in the deposit rate paid to banks for their reserves.  

Equity markets may hit a bit of a speedbump after an incredible run this month. This kind of news is a potential catalyst. The FTSE is up 5% in September and the S&P is up 4.4%. However, the inability of bond yields to make any sort of move higher, despite stronger data and rallying asset markets provides very solid under-pinning, so any dip here is likely to be a correction within that uptrend.

Economic data today has shown a slight slowdown in the pace of decline in Japanese department store sales – now down 8.8% year-on-year. The Eurozone released current account data for July, posting a euro 6.6 billion surplus. In the UK, August money supply data showed a further slowdown with M4 growth at 12.6%, the weakest since last September. The BoE also released its ‘Trends in Lending’ report, reporting little new demand for business loans and ongoing caution on house prices and jobs. The MPC has embarked on a course of quantitative easing in order to force interest rates down and push money directly into the economy. This policy can only work with a significant lag but frustration seems clear.

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It has been another excellent overnight trading session in financial markets for Asian stocks and currencies. That’s a reminder that when we all share a single global monetary policy, those who do not suffer the credit rationing – which is so evident in the UK and US – are in a very strong position. That doesn’t mean that they can drive the global economy forward – there are simply not enough consumers to compensate for the weakness of demand in the US – but it does help soften the blow and critically it does help the flow of money around the global economy.

If there is one question I get asked more than any other at the moment, it is how far equity markets in particular can rally in the absence of a durable economic recovery. I think the answer is that they can go a lot further than the scaremongers accept. There are several considerations here. Firstly, corporate profits can bounce a significant amount on the back of economic stabilisation (as opposed to recovery) and the fall in interest costs that large-cap companies in particular have seen. Secondly, G7 equity indices contain a lot of companies that earn much of their revenue overseas. The FTSE can be driven higher by energy and commodity companies long before domestic retailers thrive. Thirdly, if the return on alternative savings goes down far enough, the value of the profits from the corporate sector appear more attractive. As the term structure of interest rates is driven lower and expectations of higher rates are pushed further into the future, equities do respond. Finally, many of the lowest-priced stocks were in the financial sector – where they are not valued as a function of future earnings but on the basis of the probability of survival independently of the public purse.

For the above reasons, and as long as monetary policy remains accommodative globally, I think there is more upside in equity markets and I think that the positive mood in emerging markets will continue to drive major economies’ asset markets. The bigger question for me is whether this will help to trigger the revival in consumer confidence and in demand that the major economies need before anyone can be confident that the current better economic data is more than a temporary event that will be reversed in due course. My suspicion is that the feedback from rising asset prices to consumer confidence, to bank profits and from there to lending behaviour, is strong enough to see the current tentative revival in activity last longer than most economists believe. At the moment, third quarter growth forecasts are being revised up, but nobody believes this can be sustained into 2010. I think that belief will be tested.  

This morning’s major economic data release was UK retail sales data for August. This was disappointing, with sales flat on the month, up 2.1% in volume terms on an annual basis, after downward revisions to past data. Reports from retailers had suggested that August started slowly but that sales picked up at the end of the month. I will be looking for better data in September and am not unduly concerned. But there is no doubt that the Bank of England, and Mervyn King in particular, will want to see a lot more signs of economic recovery taking root – and of bank lending picking up – before its dovish tone changes.

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There continues to be incredible reluctance on the part of both markets and policy-makers to believe that the stronger economic data we are currently seeing is sustainable. The US saw very strong retail sales data yesterday for August, with a 2.7% increase on the month. That is boosted by ‘cash for clunkers’ but excluding auto sales, the gain was still an impressive 1.1%. It can be argued that some of that is due to higher gasoline prices, since the US data shows the value of sales rather than the volume, as is the case in the UK. But even excluding both gas station sales and cars, the gain was 0.6%, compared to a market expectation of no change. US bond markets, however, pretty much ignored the data. 10-year yields are almost half a percentage point lower than they were in early August. And without interest rate support, the dollar received no boost either.

There are two factors at play here. The first is that market participants see stronger economic data as temporary and policy-induced. The need to reduce debt levels on the part of consumers, businesses and governments, combined with the difficulty many people experience in getting access to credit, casts doubt over the sustainability of recovery. Secondly, central bankers seem united in their expressions of caution about recovery. Every utterance by a G7 central banker over the last month has made it clear that monetary policy will remain accommodative for a very long time.

A really prolonged period of easy money continues to be very positive for gold prices – which are back through $1,000/oz with a vengeance – and also for resource economies and currencies in general, and for equity markets too. For sure, equity markets cannot rally indefinitely without stronger economic recovery. That is why there is so much attention paid in the media to those who warn that this equity bounce will be unsustainable. However, as a general rule, monetary reflation on a co-ordinated basis and on a huge scale is going to be positive for nearly all asset markets. Equity and precious metal trends seem to me to be set to continue.

This was the background to Mervyn King’s testimony to the Civil Service Select Committee yesterday. Mr King remains very concerned that the Bank of England’s (BoE) efforts to pump money into the economy are simply resulting in increased deposits by the banking sector with the BoE. These concerns prompted Mr King to vote for a greater increase in quantitative easing than his MPC colleagues, and also to look at alternative measures, notably a cut in the rate the bank pays for reserves. This morning’s press concludes that perhaps Mr King ‘knows something we don’t’ about the economy. I don’t think that’s the case. What he knows is that he absolutely cannot afford to see efforts at monetary reflation thwarted by the banking system in the UK. And he is prepared to find alternative measures to reinforce the rate cuts and bond-buying that have already taken place, confident that he can unwind these when bank lending and money supply growth do finally pick up. What is clear from this is that the day when the MPC do finally increase interest rates is getting pushed further into the future. When rates do eventually go up, they might have to go up sharply to compensate for what is being done now, but that is for another day. Meanwhile, today sees UK unemployment and earnings data, with markets looking for wage growth to slow to 1.9% and unemployment to increase to 8%. The US sees consumer price data that are expected to show inflation ‘bouncing’ from -2.1% to -1.7%, while industrial production will increase by 0.6%. Core inflation meanwhile is expected to fall from 1.5% to 1.4%. If US yields barely rose after the retail sales figures yesterday, it is hard to see why soft inflation data would send them higher now.

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Mastery won the St Leger, but the winner is less important than the fact that the St Leger is now behind us. Sell in May and go away, come back on St Leger’s Day. Selling in May didn’t really work, but here we are past the traditional lull, and the S&P is pushing hard on 1050 despite the mini trade spat between the US and China. The end of recession, easing credit conditions for large-cap companies at least, and a tidal wave of central bank liquidity are doing their thing. Those of a pessimistic disposition will remind us that ‘end of recession’ isn’t the same as ‘resumption of growth’. The eternally gloomy will warn us that this bubble is as bad as the last and our day of reckoning will come again. The rest of us will simply take pleasure in the fact that a terrible collapse in asset prices and the worst recession in our lifetimes (well, mine, anyway) are behind us.

For those of us in the UK, we also got the heartening news overnight from the RICS survey that Chartered Surveyors are now, finally, optimistic. A positive balance of 10.7% of those surveyed reported that prices rose last month. That the balance is positive is good news. It’s the best figure since July 2008 and is significantly stronger than City economists expected. We get inflation data this morning, probably showing the annual rate of consumer price inflation (CPI) dropping from 1.8% to 1.4%, though the main focus will be on the quarterly grilling to MPC members by the Treasury and Civil Service Select Committee. Mervyn King will no doubt be asked to explain why the banks have failed to turn quantitative easing into more bank lending. The dovish stance that Mr King has taken of late is in sharp contrast to his reputation as a dyed-in-the-wool monetary hawk. When he does become more optimistic that the Bank has turned the tide and credit conditions are genuinely easing, he will doubtless revert to his hawkish stance but that is not yet imminent.

The US sees retail sales data this afternoon, which will be boosted by the ‘cash for clunkers’ programme. The consensus forecast is for a 1.9% gain but it could be even stronger. Strip out cars, and the gain is expected to be a more modest 0.4%. Strip out gas station sales – boosted by higher gasoline prices – and the consensus looks for a flat outcome. How that figure comes out, will help determine underlying sentiment regarding US consumer demand. Upside surprises would fuel a further retreat by the Treasury market, which saw yields edge a bit higher yesterday. The dollar has been undermined by falling rate expectations so we will be watching the figures, but equities may not be unduly influenced as long as the recovery isn’t marred by too dramatic a rise in rates – which seems highly unlikely.

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The spectre of protectionism is back in the forefront of market participants’ minds and dominating the front pages of the business press. A 35% duty on imports of tyres from China is, of itself, not a huge deal when you bear in mind that the US imported only $1.8bn in tyres from China last year (out of total imports of $2,523bn, and imports from China of $338bn). The question is whether this will escalate into something much more meaningful as US authorities are forced to appease workers, and as President Obama makes political trade-offs in order to maintain support for healthcare reform.

Any sign of a return to protectionism is scary. It is very bad for global growth and for global capital flows. If Chinese/US trade was to deteriorate, that would send consumer prices higher, reduce Chinese appetite for US debt and send interest rates higher, which in turn would send stock markets lower and undermine the dollar. So for the press and markets to be apprehensive is natural. However, the fact that the US chose to push imports on a sector that is politically important domestically (part of the US auto industry) but not really of great importance for global trade, is significant. The Chinese will doubtless retaliate with tariffs of their own, but both parties are well aware of the need to appease domestic audiences and also of the need to nurture the first tentative signs of global economic recovery with considerable care. Bottom line: there’s a lot of posturing but this is a spat between friends which will pass without great incident.

Meanwhile, the European Union is now forecasting that recession has ended and will be replaced by anaemic growth. A forecast of 0.2% growth in Q3 and 0.1% growth in Q4 is hardly a ‘V-shaped’ recovery, and the EU warns that growth is dependent on the accommodative policies which have produced recovery, being kept in place. But with even the most cautious forecasters now conceding that recession is behind us, there is a good chance that optimism can spread. Likewise in the UK, the Council of Mortgage Lenders reported this morning that June saw a further recovery in lending for both house purchases and for remortgaging. The numbers are soft historically but loans for new house purchases are now higher than they were a year ago (up 24% to 56,000).

We have a very busy week ahead of us for economic data. In the UK, the MPC’s King, Bean, Dale, Barker and Miles are testifying to the Treasury and Civil Service Select Committee on the Inflation Report tomorrow. We also see RICS house price data tonight, CPI inflation for August tomorrow, unemployment data on Wednesday, and retail sales on Thursday. The US gets producer prices and the August retail sales report tomorrow which will likely be strong, boosted by ‘cash for clunkers’. Consumer prices are out on Wednesday and housing starts on Thursday. So far, the data all support the idea of economic stabilisation, but don’t really shed much light on the debate between those who fear a double-dip recession and those looking for stronger growth in the coming few quarters.

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The US released July trade data yesterday, which showed a rebound in the deficit, centred on a rebound in the deficit with the Pacific Rim economies. ‘Cash for clunkers’ plays a part and I am always wary of reading too much into one, or even a few months’ data. However, the data does raise some important question marks around the idea that the world ‘will never be the same again’. That idea is based on the notion that having gorged ourselves with cheap credit, creating huge debt levels and fuelling massive global imbalances, we are too sensible to make the same mistake twice. OK, it is also based on the notion that bankers won’t lend us the money to repeat past mistakes. But cash for clunkers is subsidised spending to encourage us to save more slowly. Near-zero interest rates are an incentive not to save, and only the banks’ vulnerability is stopping them passing it on. And if I know anything about human behaviour, it’s that we don’t easily kick habits as well-entrenched in the Anglo-Saxon psyche as shopping.

The biggest potential surprise is a return to debt-financed consumption in the US. But if it happens, Asian economic prospects will improve further, and Asian central banks’ currency reserves will grow even further. That money will once again be re-cycled back into the US Bond market, depressing yields, helping asset markets generally. Money would flow out of the US into higher-yielding currencies, and the flow into hard money proxies like gold would increase. And the world’s economists would, this time, fall over each other to warn that this was unsustainable.

This argument is going to gather momentum in the coming days and weeks because all the commentators who cannot imagine how economic recovery could possibly take root will grasp the idea of an unsustainable recovery with both hands. The army of bearish equity analysts out there will grasp the idea of a liquidity-fuelled and therefore unsustainable rally.  And both the dollar’s weakness and the bond markets’ resilience will be explained.

As I pointed out at the start, reading too much into one month’s economic data is dangerous. However, the combination of improving US economic data and incredible resilience by the US bond market will do two things. The first is to provide some confidence that recovery will not be throttled by inflation fears and the size of public sector deficits. As long as yields stay low, the Fed will be able to keep rates down. Secondly, the fuel for the asset rally (be it in equities or in precious metals) will remain in place.

Today’s news has included a raft of robust data in China, where industrial production rose 12.3% in the year to August, retail sales rose 15.4%, and the trade surplus grew to $15.7bn. In the UK, producers’ output prices rose 0.2% in August. Later this afternoon we will see preliminary September US consumer confidence data from the University of Michigan, which will likely bounce from 65.7. Markets will also remember the 8th anniversary of the 9/11 attacks in New York.

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According to the US Federal Reserve’s Beige Book survey, 11 of the 12 regional Fed branches report stable or improving activity in August (click here) though retail sales are flat, labour markets are weak, and wage pressures are minimal. In short, as is the case in the UK and Europe, stabilisation is a bigger theme than outright recovery. Nothing there to alter a view that inflation will remain docile and the economic recovery needs to be nurtured with easy fiscal policy and a long period of very low rates.

Economic stabilisation is enough however, to allow the US Treasury to sell a record $20bn in 10year Notes at just over 3.5% yields, with stronger than average demand, for Kraft to be able to line up $8bn in funding for its potential takeover of Cadbury’s, for credit spreads to reverse all of the widening seen in August and test new lows for the year this morning, and for US equity indices to test cycle highs while in the UK, the FTSE is back at levels last seen in September 2008.  Asset markets do not, at this stage, need a significant economic recovery.

The easing of credit conditions for large-cap companies is starkly demonstrated by reports of Kraft’s ability to find funding for the attempted takeover of Cadbury. That they can get commitments for such a big loan is impressive. So is the rate they may end up paying. The 5-year Credit Default Swap rate on Kraft – an indication of where they can borrow money relative to Libor – fell from 140bp last November to under 30bp last month. It has spiked back to 64bp in the last few days. But even if a bond issue had to pay a wider spread than that, the all-in funding cost (with US 5yr rates at 2.75%)  could be between 3 ½ and 4%. That is not onerous. This is for a large non-cyclical credit, but the fall in credit costs has spread down the credit spectrum. The European iTraxx Crossover index is a basket of 45 credits, with ratings in a BBB to BB range. The 5yr yield on this index has fallen from over 14% last November, to under 9% now. As a guide, it was at 8% at the start of 2008 before the crisis really started.

These easier credit conditions have clearly not spread to small and mediums sized businesses, or to households, who are reliant on bank lending. But they are important for two reasons. Firstly, they are a sign that easy monetary policy is trickling into the economy, albeit heavily rationed. Secondly, lower interest costs are a significant driver of both increased corporate investment and of increased profits. Corporate profits can bounce on the back of reduced labour and interest costs, even in a very modest economic recovery.

Today’s main event is the MPC meeting, which I discussed yesterday. The MPC is clearly annoyed that too much of the money the bank of England is injecting into the financial system is simply coming back to it in the form of increased reserve balances and is tempted both to increase its asset purchases (from £175bn to £200bn), and cut the rate it pays for reserves (from 0.5% to 0.25% or zero). I have doubts as to whether cutting the rate the Bank pays for reserves will achieve anything, but the temptation to act will persist. However,  with house prices rising again in August according to Halifax (+0.8%) and with consumer confidence at its best levels in over a year, according to Nationwide,  there is a strong case for delaying any further policy moves for a month or two. By which time, easier credit conditions may indeed have trickled down to the wider economy.

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Good morning. Neil was kind enough to introduce me as the new ECU Chief Economist. We were competitors for many years, he was a client for the last few and now we will work together for the ECU Investment Committee.  I’ve been here for a week and markets are definitely at an interesting point. The one constant is that Central Bankers and Finance Ministers remain committed to reflating the world’s financial system and the global economy. Martin Wolf, in this morning’s FT, urges fiscal and monetary leaders to resist any temptation to withdraw stimulus too soon. My sense is that while there will be much debate about the need for a co-ordinated approach to stimulus withdrawal, that will simply ensure that stimulus remains in place for even longer than otherwise. There is just too much at stake, and as long as bank lending remains depressed and inflation remains low, the easy course of action will to do nothing.

As gold broke through $1000/oz, dollar bears became increasingly vocal yesterday and a sharp move saw psychological levels break. The prospect of rates staying low for a very long time (the Federal Reserve last night announced a record $21.6bn fall in consumer credit for July), combined with on-going fears about the currency effect of quantitative easing, and talk about replacing the Dollar as the world’s dominant reserve currency, all make a persuasive argument for dollar weakness. And with the US market returning from its Labor Day weekend, I sense that many people are looking for a bandwagon to get on. Yet, having seen sharp moves in GBP/USD, USD/JPY and EUR/USD, we have lost momentum pretty quickly. Markets are grabbing at themes but lacking real conviction (or risk appetite) to drive them further. That assures choppy trading conditions, though the underlying reflationary theme will remain in place as long as easy policy and (gradually) improving economic conditions continue.

The concerns about the UK recovery that we saw with weak BRC retail sales data yesterday were totally reversed by strong industrial production, and the news that Moody’s does not expect the UK to lose its triple-A credit rating. Sovereign credit ratings for large economies should not be treated the same way as corporate ratings, because countries have the right to print money, so only default if it is politically attractive, rather than because it is an economic necessity. However, the mood surrounding the UK economy, which took a big lurch downwards in August, is recovering. Sterling is still the most hated of the major currencies, because the UK is particularly sensitive to a financial sector crisis, but that is why it has lagged other ‘higher-yielding’ currencies such as the Australian and New Zealand Dollars. The next big test comes tomorrow with the MPC meeting. There has been talk in the press and from City analysts, that the MPC could further increase the size of their bond-buying operating, or cut the rate the Bank of England pays for banks’ reserves. This talk reflects the frustration that the MPC clearly feels at the UK banks’ reluctance to increase lending to the economy. There is clearly a risk that the MPC takes further action but I tend to think they will wait for a few more months to see how the environment changes. Firstly, they increased the size of their bond buying operation last month, and to act again so soon would smack of panic (and that seems unwarranted). Secondly, reluctance to lend is largely a function of the difficulty the banks have faced in raising term funding, and cutting reserve rates would not change that.  We will have to see how this plays out, but if the MPC does nothing tomorrow sterling, which has been the weakest of the major currencies over the last month, can continue its rehabilitation.

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