Market Outlook - BNP PARIBAS - Investment Services India

West has consumed future income and is now deleveraging.
This de facto means the West will have to
convert to net exports while China will have to move
in the opposite direction. In the end, re-balancing will
take place and the result of rebalancing will be
deceleration in currency reserve growth.
The implication for currency markets is
straightforward. There will be less USD supply
coming via reserve reallocation.
Road map to sterling weakness
According to our PPP models, sterling is fairly
valued, but this should not lead to the misinterpretation
that the GBP will rally in the medium
term. If at all, sterling has only short-term upside,
with the long-term outlook remaining heavily biased
to the downside.
The BoE will stop QE-related monetary expansion as
its inflation rates have surprised to the upside. This
means that there needs to be an alternative buyer for
the Gilt market. Bear in mind, the GBP 178bln budget
deficit forecast by the government for 2009 has been
entirely funded by the BoE, which has absorbed GBP
198bln in debt securities (mainly Gilts) from the open
market (see Chart 9). This operation allowed yields
to remain comparatively low despite the government
borrowing record amounts. In the absence of the
BoE extending its QE operations, the Gilt market
must attract private funds. We doubt that these
private savings can be secured from domestic
sources. Ahead of the general election, the
government will try to create a feel-good factor. Most
of its support measures are aimed at supporting the
demand side of the economy, including housing.
Hence domestic savings are back in decline and, in
the absence of domestic funds being invested in the
Gilt market, the UK will have to import capital. This
will work in favour of sterling for the next couple of
weeks but will came at a high cost as Gilt yield
differentials rise, moving domestic borrowing costs
up.
After the election there will be the reality check and
that will be brutal. It will be Hobson’s choice: either
cut deficits (which will weaken demand) or face rating
downgrades (which will drive borrowing costs
higher). But higher borrowing costs are obviously the
worst option for an overleveraged economy. After all
those years of exuberant consumer spending on
future income expectations, it is clear that domestic
demand can no longer be the main source of
economic activity. The UK will need to become
supply driven, but the chief thrust of the Brown
government’s economic policy has been to create the
aforementioned feel-good factor. Instead of
promoting the supply side of the British economy,
everything has been done to support private
Chart 9: BoE Asset Purchases by Type
Period/ WE Commercial Gilts Corporate Total
paper
bonds
2009 Q3 922 151,775 1,073 153,771
01-Oct-09 225 4,200 72 4,497
08-Oct-09 80 4,200 139 4,419
15-Oct-09 25 4,200 33 4,258
22-Oct-09 145 4,201 13 4,359
29-Oct-09 0 4,200 62 4,262
05-Nov-09 0 0 63 63
12-Nov-09 0 3,400 60 3,460
19-Nov-09 70 1,700 13 1,783
26-Nov-09 224 3,400 5 3,629
03-Dec-09 0 1,701 4 1,705
10-Dec-09 125 3,400 2 3,527
17-Dec-09 190 1,700 0 1,890
24-Dec-09 0 0 0 0
31-Dec-09 25 0 0 25
Amount outstanding financed by the Treasury bills as at 31 Dec
- - - -
Amount outstanding financed by central bank reserves as at 31 Dec
429 188,076 1,549 190,053
Total amount outstanding as at 31 Dec
429 188,076 1,549 190,053
Source: BoE
Chart 10: Foreign Holdings in the Gilt market
250,000
200,000
150,000
100,000
50,000
0
Holdings
(GBP m)
% of Total
(rhs)
40.0%
35.0%
30.0%
25.0%
20.0%
15.0%
10.0%
Q1 2006Q1 2007Q1 2008Q1 2009
Source: BoE, BNPP. Foreign holdings in the Gilt market have declined
below 30% of the total outstanding. However, the absolute holding has
exceeded GBP 200bln, representing a new high. With the BoE expected to
confirm the suspension of its QE operations next Thursday, upcoming Gilt
supply needs to be absorbed by domestic private or foreign funds. The
BoE withdrawing from QE may lead to sterling inflows as foreign accounts
move into Gilts. Nonetheless, foreign buying interest in the Gilt market will
only be generated if Gilt interest rate differentials rise; we doubt the
economy can take that.
consumption including housing. This approach is
unsustainable and will have to be corrected after the
election. In the unlikely event the current government
wins another term, Labour might try muddling
through by keeping government expenditure high
while trying to reduce the budget gap through a
higher tax take. This policy approach is unlikely to be
tolerated by the rating agencies and will ultimately
lead to a downgrade. A Tory government will face
equally strong hurdles. The IMF has just warned that
the British economy would not be able to withstand
an abrupt tightening of fiscal conditions in the early
stages of its current economic recovery. A fine line
between fiscal consolidation and keeping the
economy going needs to be found and currency
strength would be counterproductive to that stance.
What the UK needs is a combination of tight fiscal
and loose monetary policies which will create text
book style currency weakness.
Rob Ryan 29 January 2010
Market Mover, Non-Objective Research Section
50
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