Wednesday, 25 March 2009

Is bad news for the Treasury good for the private sector?

An intriguing post from Robert Peston raising the spectre of the Treasury failing to sell all the bonds it wanted to sell yesterday.

Is this, as he implies, plain bad news for the government because their funding is getting more expensive?

Or is it good news for private lenders - implying that investors are fed up with their "flight to quality" and are now considering private sector investments instead?

The answer is dependent on two further questions:
  1. is investors' money switching to foreign investments, UK private lending or UK equities?
  2. are investors actually running out of money to invest - the infamous savings trap, where people in aggregate try to increase their savings but fail to do so, because the attempt to save reduces total income in the economy and available savings are reduced too?
Hopefully we can find out. How could we figure it out?
  • by looking at total UK savings this month - this is not an exact science but we should hopefully be able to see if the trends are continuing on their previous path
  • by looking at the capital account balance to see if there is any turn in the amount of investment coming into or going out of the UK
  • by looking at the performance of equities (it has been on an upwards trend this month, so this could help answer question 1, though not definitively)
A key point is whether Mervyn King's comments yesterday have contributed to this - in other words, are investors listening to King's opinion of the government's fiscal policy and is this affecting their evaluation of government debt? This would have imply either that they are irrational, or that King's statement changed the outlook for the Bank of England's interest rate policy.

However, King's statement does not reveal any additional information about likely inflation; if only gives an indication about the Bank of England's likely response to inflation. If anything this information should reduce long-term interest rates and make these 40-year gilts more saleable, not less.

Thus, if traders are reacting to Mervyn King they are, strictly, behaving irrationally. This is exactly what happened when the QE programme was announced, though in the opposite direction.

Funny eh? There is an arbitrage opportunity here, if the traders' irrationalities can be predicted. Of course this type of behaviour will be corrected as it is noticed, so the arbitrage might not be available any more on these specific types of movements. But the opportunity is still there for those who have a good model of irrationality that can be applied in advance to future price movements.

Update: Econbrowser hints at signs that the worst (in the US housing market, and thus in the banking sector, and thus in the real economy) might be over. Too early to say, of course, but we can hope...

No comments: