The Bank of England maintained its accommodative policy stance in its announcement on Aug. 5, keeping short-term interest rates at the zero-bound while continuing to put downward pressure on long-term interest rates through purchases and holdings of fixed-income securities.
Our proprietary index implies that financial conditions are ripe for a robust recovery of the British economy.
As a result, our RSM UK Financial Conditions Index stands just below one standard deviation above neutral, implying that conditions are ripe for a robust recovery of the British economy heading into the latter portion of the year and an economic expansion next year.
This has been the standard for monetary policies throughout the world’s developed economies since the outbreak of the coronavirus and the worldwide collapse of equity markets in March of last year.
The consistency of those policies—and the knowledge that monetary authorities will quickly do whatever it takes to right the ship—has reduced perceptions of risk in financial markets, setting the stage for economic recovery.
Central bankers recognize that monetary policy is transmitted to the economy through financial conditions. That is, the lack of liquidity in the commercial markets or a deficit in investment during times of financial or economic stress can be alleviated by flooding the markets with cash and by lowering interest rates.
As our analysis shows, financial conditions in the United Kingdom and the United States have recovered to the point that below-normal levels of risk are being priced into financial assets, achieving an overall level of accommodation necessary for the smooth operation of commerce and business investment.
It’s no coincidence that financial conditions in both the U.K. and United States remain well above normal. We live in an interconnected world—certainly at the financial market level—and events tend to spill from one economy into another. So whether it’s the European debt crisis or Brexit or the outbreak of the delta variant in the United States, events will have an impact on financial markets throughout the world.
Coordination among the world’s central banks has developed to the point in recent decades that there is a uniform monetary policy in response to the shocks and then to the recoveries that followed.
For now, monetary authorities in the United States and U.K. are in holding patterns, anticipating higher growth but waiting for the labor markets to sort themselves out before altering policy, all while remaining wary of the delta variant’s spread.
Bond market spillover
Because of the financial markets’ global nature, it’s hard to discern the difference in individual bond market reactions to the major economic and financial events of the past decades.
Long-term interest rates in the U.K. and the United States have been in secular decline in response to slowing growth among the developed economies, with Brexit turmoil having a more intense impact on gilt yields than on U.S. Treasury bonds.
So it should be of little surprise that bond yields in the U.K. and the United States have declined in recent weeks despite prospects for improved growth. The yield on 10-year gilts flirted with yields below 0.5% on three consecutive days in the first week of August, keeping in step with the pattern of U.S. Treasury bonds that had similar dips below 1.15%.
There are several likely reasons for this downturn in yields. These include the increased demand for bonds—because of the near-zero return on short-term securities—butting up against a diminished supply of bonds because of central bank asset purchases. And if the local economies were to continue to open up and tax revenues increase, that could lower the need for bond issuance.
But unless this turns out to be a short-term technical correction, there is the likelihood that the bond market is reconsidering the ability of economies to quickly snap back to normal.
The health crisis
The world remains in the midst of a health crisis, and total global economic activity will not return to pre-pandemic levels until vaccines have had broad distribution.
Although the COVID-19 vaccination program in the U.K. appears to have blunted the rise of the delta variant, a substantial segment of the U.S. population (and now the French) remains unvaccinated.
Newly reported cases of COVID-19 infections in the U.K. have dropped from 47,000 per day six weeks ago to about 26,000 per day, according to data compiled by Worldometers. That the virus is reportedly affecting unvaccinated younger people lends hope that this fourth wave will not be as deadly as earlier spikes. Nevertheless, 26,000 new infections each day is not a small number.
Long-term economic scarring
After five quarters of decline, the consensus among economists polled by Bloomberg is for the U.K. economy to finish the year with substantial growth in the third and fourth quarters, then grow by more than 5% next year before settling back down to earth with 2% growth in 2023.
The Bank of England revised down its estimate of long-term economic scarring from 1.25% to 1%.
What we cannot yet determine is the extent of the economic scarring caused by the loss of income, workers’ absence from the labor force during the economic shutdowns, and changes to what was ordinary life.
So we look to the financial markets as an indication of where people are willing to put their money. That the Bank of England revised down its estimate of long-term economic scarring from 1.25% to 1% implies that the economy can grow faster without increasing the risk to the outlook from inflation than previously expected. That should provide some degree of relief to policymakers and to the firms that comprise the U.K. real economy.
The degree of risk being priced into the financial markets has been shown to lead economic growth in the coming quarters. And while other asset classes have maintained a more upbeat posture of low volatility and reduced risk as the virus was beaten back, the bond market could be having second thoughts.
The spread between 10-year bond yields and three-month money market rates has traditionally been an indicator of perceptions of growth. An increase in this yield-curve spread suggests a growing economy, better able to support higher long-term interest rates relative to short-term money-market rates.
The shrinking yield-curve spread in recent weeks suggests that the renewed spread of virus in the U.K. and the lack of vaccines in the developing economies deserves a measure of caution.
That has resulted in moderation of U.K. financial conditions, pushing the RSM UK Financial Conditions Index—which had reached one full standard deviation above normal at the end of June—to 0.8 standard deviations above normal. That is still an elevated level, but is tempered by uncertainty surrounding the virus.
We expect governments in developed economies to continue their attack on the virus in the rest of the world and to begin domestic programs for booster shots if needed. That will require a large redirection of fiscal spending that will undoubtedly pressure interest rates higher. But it’s an investment that needs to be made and it will ensure future economic growth.
For more information on how the coronavirus pandemic is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
