There can be little doubt we are currently living in uncertain times. For me, there is no better evidence for this than the swings in money market futures rates.
After all, traders are supposed to be the people who are closest in touch with the pulse of the market. They are staking real money on their opinions of the most likely future trends.
Using money markets as a guide gives us the advantage of drawing on a full range of views rather than being reliant on a single individual’s opinion.
Surely, if there is any reliable guide to trends in interest rates, it will be apparent in the implicit rates derived from the pricing of futures contracts?
But when we look back at the rates implied by such contracts in the past six months, the outstanding feature is one of marked volatility.
At the beginning of the year, three month Libor futures for December 2008 were about 5%. By mid-February, they had slipped to about 4.5% on concerns about the risks of a UK recession; and the rate was back to 5% at the end of April.
By the end of May, fears about an acceleration in the rate of inflation, exacerbated by the hawkish stance adopted by the Bank of England in its quarterly Inflation Report, had taken this rate up to 6%. And at one point in mid-June, this rate reached 6.4% – a staggering rise of nearly 200 basis points in barely four months.
Well, if nothing else, one feels the money markets have got it right and three month Libor in December will lie somewhere within this range.
But are the money markets right to be so pessimistic about the prospects for the UK economy? I think not. My main reason for believing the Monetary Policy Committee (MPC) will not raise the base rate is that the current acceleration in the inflation rate appears likely to prove short-lived.
As Bank of England Governor Mervyn King’s open letter to the Chancellor of the Exchequer Alistair Darling clearly sets out, the reason inflation has moved away from target is due to increases in global food and energy costs. While this will inevitably raise the price level in the short term, it is not the same as an acceleration in the underlying rate of inflation.
For these current price rises to become embedded, either global commodity prices would have to continue rising for the next year or so – which from current levels seems unlikely – or the short-term rise in prices would have to trigger an acceleration in wage inflation. There is no evidence of this happening as yet and little sign – other than posturing by a few union officials – that it will happen in the future. There will be a squeeze on real incomes in the short term. But at an aggregate level, this squeeze will be fairly modest and will be fairly short lived. If as anticipated the price level flattens out in the early part of 2009, next year’s pay increases should provide a material and welcome boost to real incomes.
In the meantime, the short-term prospects for the housing and mortgage market appear bleak. While activity in the rest of the economy remains surprisingly robust, at least for the time being, there can be little doubt that housing and all its associated activities – mortgage lending, broking, estate agency, housebuilding – are in the middle of a profound recession. And there is little likelihood of this situation turning round in the near future. While the MPC is unlikely to raise the Bank base rate, it looks even less likely to cut the rate while the headline Consumer Price Index inflation rate carries on rising, and that probably takes us to the end of this year.
Unless the Bank of England’s Special Liquidity Scheme radically improves the supply of funding to the mortgage market, which is looking increasingly unlikely, it seems that the best the housing market can hope for is for the market to stabilise at current levels rather than suffer further declines. n
