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Don’t stamp out success by rushing economic recovery efforts

The financial markets have called the end of the recession.
Commodity prices are soaring, stock markets are up, bond yields are rising,
interbank lending costs are falling and sterling is in the ascendant. There is
growing optimism that the quantitative easing programmes launched in the US, UK
and the eurozone, allied with $1.5 trillion of spending increases and tax cuts
over the coming 18 months, will spur recovery.

But is it all too good to be true? The fact is that those investors who are
now jumping back in were battered by a slump in the prices of almost all asset
classes over the past two years. They are terrified of missing the turning

‘You can’t wait for the good news,’ says one battle-hardened fund manager.
‘If everyone knows the good news, the market will be high and you will have
missed out on much of the uptrend.’

One of the most striking recoveries is in the oil price, which has more than
doubled since hitting a four-year low of $32.70 a barrel in February 2009. ‘Oil
prices have gone from strength to strength in recent months,’ the International
Energy Agency says in its June monthly report, which raised its forecast for
demand for crude this year.

But the IEA, which advises OECD countries on energy policy, says that while
the latest surge in prices was ‘partly fuelled by signs of slightly stronger
fundamental factors’, there was evidence of speculators piling into the market.
According to the US Commodity Futures Trading Commission, futures contracts by
‘non-commercial investors’ – speculators – have shifted from a net 11,000 short
positions in early May to a net 48,000 long in June.

Barbara Lambrecht, an analyst at Commerzbank, says that many of the factors
that drove last year’s boom are present again – specifically a resurgence of
geopolitical factors.

‘Political unrest following the presidential elections in Iran and bombing
attacks on oil plants in Nigeria represent an explosive mix for the oil market,’
she says.

Price recovery
Oil is not alone in pricing in recovery. The price of copper, lead and nickel
all rose by between 13% and 20% in the month to 15 June after falling as much as
50% in the previous 12 months. Meanwhile a basket of foodstuffs tracked by
Commerzbank is up 3% over the same period.

And if commodity prices are rising, then inflation may not be far behind. The
bond market certainly thinks so. Yields on 10-year government bonds, which act
as a market measure of interest rates, hit 4% on both sides of the Atlantic in

Analysts say the so-called ‘bond vigilantes’ – investors perpetually worried
about rising inflation and ballooning budget deficits – are sending out warning
signals that central banks must soon start hiking interest rates to quell a
sudden spike in inflation.

The net effect has been to offset some of the benign impact of the
quantitative easing programmes that were designed to bring down market interest
rates. For example, the rise in UK yields from around 3% at the start of 2009
flies in the face of the £125bn of extra liquidity announced by the Bank of
England aiming to push bond yields down.

‘Though policymakers have attempted to keep rates low through quantitative
easing, their efforts now seem in vain,’ says Kim Rupert, an analyst at
forecaster Action Economics.

This increase in yields is pushing up the cost of loans offered to homebuyers
and businesses, just at a time when the economic recovery is most fragile.
Mortgage lenders in the UK have responded swiftly. Nationwide Building Society
hiked its five-year rate from 4.98% to 5.84%. Yorkshire Building Society and
state-owned Northern Rock have also increased rates. Ray Boulger, senior
technical adviser at mortgage broker John Charcol, warns that any signs of
recovery in the housing market risk might be ‘snuffed out’ by the hike in
mortgage rates.

‘Rising optimism means rising bond yields which are pushing up mortgage rates
– the irony of which will not be lost on both the Federal Reserve and the Bank
of England, which are still trying to hold yields down,’ say analysts at
research house Fathom Consulting.

Little to gain
For business the picture is even gloomier. There is little evidence that they
gained much from the fall in borrowing costs that has now been rudely
terminated. The interbank lending rate, Libor, fell sharply from its peak as the
Bank of England cut rates and pumped money into the economy. However, the
benchmark three-month rate is still hovering at around 1.25% – 75 basis points
above the Bank of England’s base rate – when in normal times the two are almost
in line.

A special survey by the Bank of Englandís regional agents in June found that
more than 80% of companies said external finance, including bank finance and
trade credit insurance, had become more expensive and harder to obtain over the
past year. This was echoed by the Confederation of British Industry (CBI). Its
May survey of credit conditions showed that just over half of companies that had
secured new or renewed credit lines reported a rise in charges, compared with
just 10% reporting a cut. This was only a marginal improvement from its February
survey, carried out before the Bank cut base rate to 0.5%, when 57% reported a
rise in borrowing costs.

‘Evidence of a loosening in corporate credit conditions has been limited at
best,’ says CBI chief economist Ian McCafferty.

At the same time, sterling has started to regain much of the ground it lost
after it emerged that the economy was heading for a nasty recession. Since
hitting a trough below $1.40 in March, sterling has jumped by almost 18% against
the dollar by mid-June and by almost 12% against a basket of its main trading
partners’ currencies. Much of the boost came after the National Institute for
Economic and Social Research declared that UK output had risen in April and May.
This boosted hopes that, on 24 July, the Office for National Statistics would
reveal that the economy had grown in Q2 2009 for the first time since the winter
of 2008.

The cruel irony is that a return to growth for the UK economy will have been
driven by these very same factors that are now rapidly unwinding. Falling
commodity prices, a weaker sterling and a slump in mortgage rates combined to
give a boost to both consumersí wallets and exportersí price list. Now they are
all climbing again, economic recovery could itself reverse.

‘The gain in competitiveness is melting away,’ says Stephen Lewis, chief
economist at Monument Securities with reference to sterling’s climb. ‘Some
anecdotal reports have suggested that the spending of many households has been
underpinned, so far in the economic downswing, as a result of falling mortgage
rates and declining inflation pressures. These benefits are unlikely to extend
much further.’

Financial investors may be right in calling an end to the recession. The
danger is that by responding so quickly to hopes of a return to economic boom,
they risk trampling on the very green shoots that sent them on a buying spree in
the first place.

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