What is really driving capital from the UK?

Mark Carney says the interest rate cycle is on the turn in the UK, which is partly behind capital flowing out

There is something slightly odd about the links being widely made between the large capital outflows from the UK in July and August to fears that Scotland would vote for independence.

At the time, opinion polls and bookies' odds were showing a very high probability of Scots voting to stay in the union. There was no evidence of investors being anxious about Scottish independence then.

So it is extremely unlikely that the net $26bn (£16bn) of financial capital that left the UK in July and the $27bn that was withdrawn in August (according to data supplied by Crossborder Capital, which has been widely reported) had anything much to do with nervousness about the possible separation of Scotland.

There is a much better explanation for what happened. A colossal penny has dropped, thanks in part to remarks made by the Bank of England governor, Mark Carney, that the interest rate cycle is on the turn in the UK.

Or to put it another way, after six years of almost free money in the UK, market interest rates are rising and the official rate looks set to rise in months. Which all stems from a very good thing - the strength of the UK's economic recovery.

'Apparent paradox'

When interest rates rise, the price of bonds fall (to remind you, the coupon on a bond is fixed, so for the yield or rate on the bond to rise, the price of this asset has to fall).

In other words, international investors have worked out that the trend for UK bond prices - including government bonds - is downward. And have been selling them and pulling their money out of the UK.

There is what looks like an apparent paradox therefore in the fact that the UK is currently growing faster than any of the other big developed economies - which is that for a period there are better places to put your money if you are an investor in bonds.

And there is plenty of evidence that it is a flight from UK bonds that is behind the big capital outflow: UK government bonds now yield massively more than they did just last year, especially compared with the yield on German and French bonds (where interest rates will remain depressed for many months - because of its endemic stagnation).

Capital withdrawal rising?

That said, there is evidence of capital outflow for Scottish reasons since opinion polls started to show the yes and no campaigns neck and neck just over a week ago.

The pound has dropped to its lowest since November. There was an outflow of $672m from UK equity funds in the past week according to a funds data provider, EPFR. And Morgan Stanley said on Friday that data on transactions in shares points to "some of the largest UK equity selling on record".

None of this is surprising. As I have been saying and writing for months, there are huge financial uncertainties associated with breaking up such a close political and economic union that has endured for more than 300 years.

What is more, if polls narrow again, it would be very odd if the pace of capital withdrawal from the UK did not accelerate - especially given the rather stark warnings about its implications being made by overseas banks such as Deutsche and UBS.

But it is vital not to confuse what may be happening now with what actually happened in July and August. The capital outflows then actually represented investors waking up to the renewed strength of Britain's economy (including Scotland's).