The strain on Spain eases

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Over recent weeks it has been interesting to observe Spanish government bond yields continue to plummet. The 10yr yield fell a further 15bp yesterday to 6.3% – just four weeks ago, it was up near 7.75%. Nearer the front of the curve, the gains have been even more impressive – for instance, the 2yr yield is now just 3.65%, whereas a month back it was above 7%.

Although the Bundesbank reiterated yesterday that they were adamantly opposed to bond buying, it is clear that the market believes something is cooking in Brussels. Some commentators are suggesting that the ECB is contemplating purchases of short-dated paper (perhaps under one year to maturity) as long as the relevant sovereigns apply directly to the rescue funds. There was also speculation yesterday that the ECB might set explicit interest rate targets. As European leaders prepare their briefing papers for later in the week, Greece is a topic that will figure prominently as well.

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Commentary

The UK’s miserable trade performance. British Chancellor George Osborne is under enormous pressure to release the hand-brake on fiscal austerity after three quarters of negative growth, but as is often the case commentators are firing at the wrong target. Because the real problem for the British economy is the incredibly disappointing performance on the trade side. Despite what has been a very competitive exchange rate over recent years, export growth has been disappointing and there has been a lot less import replacement than there should have been. For instance, in July the goods trade deficit  was the second highest on record, an outcome that should be ringing alarm bells in Whitehall. Sure, the size of the trade deficit in real terms has fallen appreciably in recent years, but the fact that it is still so high just re-emphasises the considerable structural limitations of the economy.  In relative terms, Britain’s export performance has lagged well behind other major economies. Since the end of 2006, the value of Chinese exports has risen by 87%, in America the comparable increase has been 44%, while in the UK it has been 29%.  Net exports was rightly regarded as a critical component of the long term financial and economic adjustment process for the UK economy, as a necessary counterweight to fiscal consolidation. If the former continues to underperform, then the political pressure on Osborne and the Conservatives to abandon the course with fiscal punishment will soon become intolerable. Right now, if Osborne and Cameron want to make their life easier, they need to concentrate on stimulating trade. Sure, it is tough in these chastened times, but it is surely not against the wit of this government to come up with genuine initiatives to encourage both exports and import replacement.

Commodity inflation. Not getting the attention it deserves is the recent spike in oil and food prices. Israeli sabre-rattling and a significant tightening in US oil inventories have contributed to a marked jump in the price of oil over the past couple of months – Brent crude two months ago fell below USD 90 a barrel, but is now above USD 115, an increase of more than 25%! The current oil price is roughly USD 13 below the peak set back in early March. For developing countries that rely on imported fuel, such as India and China, this recent price spike renders policy-making even more treacherous, at a time when both foreign and domestic demand have clearly weakened. To compound the misery in much of the developed world, much higher food prices are headed their way after the worst US drought for many decades. July temperatures in the America were the hottest on record. Food represents a much larger proportion of the consumption basket in developing countries, and so household budgets are stretched very quickly once food prices rise materially. Prices for mandatory foodstuffs such as corn, wheat and soybeans have soared in response to a global shortage for these commodities. The jump in corn prices has re-ignited the debate in the US regarding the usage of corn in ethanol production – two-fifths of the US corn crop is used to make ethanol. According to the United Nations Food and Agriculture Organisation, global good prices were up by a staggering 6% last month. At a time of weak global demand, with Europe still in a financial vice and with central banks in the advanced world running out of monetary medicine, rising commodity prices adds yet another layer of complexity to the task for policy-makers.

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