Eurozone monetary statistics for July were better than feared, with M1, M2 and M3 all rising by 0.2% on the month.

This increase undermines the argument that the recent surge in US money measures has been due to massive capital flight from the Eurozone. This argument, in any case, is inconsistent with the stability of the euro / dollar exchange rate.

Despite a rise in July, Eurozone real M1 – the best monetary leading indicator of the economy – is still down by 0.2% over the last six months. The rate of contraction, however, is the smallest since November 2010 – see first chart. This suggests that a recession would still be avoidable if the ECB eased policy aggressively, reversing the rise in its repo rate and committing to large-scale bond purchases.

M1 comprises currency in circulation and overnight deposits. A country breakdown is available for deposits but not currency. Interestingly, this breakdown reveals a return to real growth in the core while contraction continues in the periphery – second chart. This may reflect a flight of deposits out of peripheral banks rather than signalling an improving outlook for core economies.

The combination of strong US and Japanese numbers with a slower decline in Euroland resulted in six-month growth in G7 real narrow money rising to 4.8% in July, the fastest since May 2009 – third chart. Its pick-up started in March, suggesting that global economic momentum will start to improve from September, allowing for the normal six-month lag. For the economy to enter a recession, narrow money velocity would have to plunge. A decline on the necessary scale would probably require a Lehman-style shock, such as a chaotic unravelling of the Eurozone.

The Asset Purchase Facility is in profit by an estimated £30 billion on the £200 billion of securities, mostly gilts, bought in 2009-10. The authorities could book an immediate fiscal gain by closing down the Facility, cancelling its gilt holdings and transferring responsibility for its Bank of England loan to the Treasury. This would cut public sector net borrowing by £19 billion this year and up to £8 billion in future years.
 
The Asset Purchase Facility bought a net £200.0 billion of securities over 2009-10, of which £198.3 billion were gilts. According to its latest annual report, the Facility was in profit by £9.8 billion on 28 February 2011 (the profit is recorded in the accounts as a liability to the Treasury). The profit on that date comprised net interest receipts of an estimated £11.5 billion offset by a capital loss of £1.7 billion. The Facility enjoys a net interest surplus because the running yield on the securities portfolio is about 4.5% while it pays Bank rate, currently 0.5%, on its £199.9 billion loan from the Bank of England. The Facility’s profit is currently excluded from the targeted public sector net borrowing measure but will be included on its closure, following the sale of securities.
 
The scheme’s profit has ballooned since February as gilt yields have fallen sharply – the 10-year yield has declined from 3.69% on 28 February to 2.72% yesterday, according to Thomson Reuters Datastream. A back of the envelope calculation suggests that the profit is now about £30 billion, comprising net interest receipts of £15 billion and a capital gain on securities of £15 billion.
 
The net interest surplus is permanent but the capital gain will disappear if gilt yields reverse their recent fall. Indeed, by the time the Bank chooses to sell the gilts, yields may have risen sufficiently to push the scheme into loss, despite a rising interest surplus.
 
To avoid this risk, the proposal is that the authorities should crystallise an immediate gain by closing down the Facility in the following way:
 
1.    The Treasury / Debt Management Office cancels the gilts held by the Facility.
2.    In return, the Treasury takes over the Facility’s loan from the Bank.
3.    The Facility’s cash holdings – reflecting its net interest income – are transferred to the Treasury.
 
This would benefit the fiscal accounts in two ways. First, the one-off transfer of the Facility’s cash would reduce public sector net borrowing by £15 billion in 2011-12. Secondly, the replacement of higher-yielding gilts with a low-interest loan from the Bank of England would cut the debt interest bill by an estimated £4 billion in 2011-12 (if closure is effected by the end of September) and by £8 billion in future years, assuming an unchanged level of Bank rate.
 
So public sector net borrowing would be reduced by an estimated £19 billion, or 1.2% of GDP, in 2011-12 and by £8 billion in future years, for as long as the Bank of England maintains Bank rate at 0.5%.
 
Possible objections to this proposal include:
 
The Bank should retain the gilts in order to sell them back to the market at a future date when credit and broad money are growing strongly, warranting a reversal of the 2009-10 monetary injection.This “problem” is unlikely to emerge any time soon, given official pressure for bank deleveraging. The Bank’s Financial Policy Committee, moreover, can employ new tools to restrain credit and monetary expansion, such as cyclical capital requirements and limits on loan to value ratios.
 
The Bank needs to be able to sell the gilts at a future date to reduce the high level of cash held by banks in their accounts at the central bank. The banks’ free cash reserves at the Bank can be reduced in other ways, such as increasing reserve requirements, auctioning term deposits or selling short-term Bank of England bills.
 
The average maturity of the national debt is reduced by the Treasury swapping longer-term gilt liabilities for a loan linked to Bank rate. True, but the average maturity of debt held by the market is unchanged by the transaction.
 
The swap means that future debt interest costs could be higher if the Bank of England were forced to jack up Bank rate sharply.True, but Bank rate would need to average more than 4.5% over the life of the cancelled gilts for the cumulative bill to be higher.
 
Closing the Asset Purchase Facility precludes the Bank from engaging in more QE. Wrong. The proposal is to close and book profit on “APF1”. The Bank / Treasury could set up “APF2” to conduct any new operations.

Revisions by equity analysts to their forecasts for company earnings suggest that the world economy is very weak but not yet in recession, while Euroland is underperforming, as predicted by relative monetary trends.

Analysts adjust their forecasts in response to company-level news so earnings revisions should provide indication of current economic momentum. The “revisions ratio” – upgrades minus downgrades expressed as a proportion of the number of estimates – correlates PMI manufacturing new orders, though is more timely and available for a wider range of countries.

The developed-markets revisions ratio fell sharply in August, suggesting that G7 PMI new orders will have moved further below the break-even 50 level – see first chart. At -0.10, however, the ratio remains above the -0.13 level historically associated with global recessions. (The corresponding level of PMI new orders is 45.)

A regional breakdown shows that Euroland has plunged beneath the critical level but the US, Japan and UK remain comfortably above it – second chart. Eurozone equity investors pursuing a strategy of “hiding in the core” have suffered a rude awakening as analysts have taken an axe to their German and French earnings estimates – third chart. Core weakness was signalled by a contraction of real M1 deposits this spring, even as the ECB was playing Russian roulette with interest rates.

According to some commentators, the recent sharp fall in longer-term gilt yields signals that investors expect the UK to follow Japan into deflationary stagnation. This is incorrect. Markets, in fact, are discounting prolonged economic weakness with continued elevated inflation.

Japanese government bond yields plunged in the 1990s as investors factored in the likelihood of a sustained decline in prices, partly due to a super-strong yen. The drop in UK yields, by contrast, has been driven by lower real interest rates rather than a fall in inflationary expectations. The real yield on 10-year index-linked gilts recently turned negative for the first time since linkers were introduced in the early 1980s – see chart. Indeed, it is unlikely that investors have ever before willingly extended a long-term loan to the British state in the expectation of an erosion in the real value of their wealth.

If investors expected deflation, they would shun index-linked bonds, causing their price to fall and yield to rise. Linkers are unprotected against a fall in the price level. Deflation, moreover, would push up real yields, resulting in a capital loss.

The negative yield on index-linked gilts could indicate that investors fear an inflationary upsurge so are willing to pay a big premium for inflation protection. In this case, however, yields on unprotected conventional gilts would rise not fall. Equities and property, meanwhile, would be expected to outperform conventional bonds because they are partial inflation hedges.

The combination of falls in conventional and index-linked gilt yields with lower equity prices is consistent with investors discounting prolonged economic weakness and steady above-target inflation. Economic weakness would erode corporate profits while encouraging the Bank of England to maintain heavily-negative real short-term interest rates. Investors, therefore, expect to suffer a smaller real loss in conventional or index-linked gilts than in stocks or cash.

The implied scenario of economic stagnation with stable elevated inflation is implausible. Chronic economic weakness, historically, has been associated with either deflation or rising inflation. Linkers would do badly in the former case and conventionals in the latter. Gilt investors are irrational to bid up the prices of both. Their current schizophrenia is unlikely to last.