Video – some thoughts on emerging markets from Hong Kong and Singapore

Posted on 17 April 2014 by Nicolo Carpaneda

I recently visited Hong Kong and Singapore to attend some conferences and meet clients in the region. While travelling, I put together a short video to share some of our views on Asian emerging economies and emerging markets in general.

As recently reported in Claudia’s Panoramic outlook here, following both the 2013 sell-off and the recent EMFX volatility experienced earlier this year, investors’ attitudes towards emerging markets have changed. Volatile capital flows, unsustainable growth models, a deterioration in current accounts, excessive credit growth and currency depreciation are key concerns for local and global investors. Some trends have become unsustainable and a rebalancing process has started. Emerging market economies will need to adjust to lower capital flows, with this adjustment taking place on various fronts over several years.

While adjustments take place, new opportunities present themselves. But not all emerging markets are equal. As emerging economies are on diverging paths, especially in Asia – some are deteriorating (eg China) while others are improving (eg Philippines or Sri Lanka) – asset allocation and stock selection will be key. Watch the video to find out our preferences.

The Great Compression of peripheral to core European risk premiums

Posted on 17 April 2014 by Wolfgang Bauer

Are investors still compensated adequately for investing in peripheral rather than core European debt, or has the on-going convergence eroded debt valuation differentials altogether? In his latest blog entry, James highlighted five signs indicating that the bond markets consider the Eurozone crisis resolved. Inter alia, James pointed out that risk premiums for peripheral vs. core European high yield credit had essentially disappeared over the past two years. Here I would like to extend the periphery/core comparison by taking a look at investment grade (IG) credit and sovereign debt.

First, let’s have a look at the spread evolution of peripheral and core European non-financial (i.e., industrials and utilities) IG indices over the past 10 years. In addition to the absolute asset swap (ASW) spread levels, we plotted the relative spread differentials between peripheral and core credit. The past ten years can be divided into three distinct phases. In the first phase, peripheral and core credit were trading closely in line with each other; differentials did not exceed 50 bps. The Lehman collapse in September 2008 and subsequent market shocks lead to a steep increase in ASW spreads, but the strong correlation between peripheral and core credit remained intact. Only in the second phase, during the Eurozone crisis from late 2009 onwards, spreads decoupled with core spreads staying relatively flat while peripheral spreads increased drastically. Towards the end of this divergence period, spread differentials peaked at more than 280 bps. ECB President Draghi’s much-cited “whatever it takes” speech in July 2012 rang in the third and still on-going phase, i.e., spread convergence.

As at the end of March 2014, peripheral vs. core spread differentials for non-financial IG credit had come back down to only 18 bps, a value last seen four years ago. The potential for further spread convergence, and hence relative outperformance of peripheral vs. core IG credit going forward, appears rather limited. Within the data set covering the past 10 years, the current yield differential is in very good agreement with the median value of 17 bps. Over a 5-year time horizon, the current differential looks already very tight, falling into the first quartile (18th percentile).

Moving on from IG credit to sovereign debt, we took a look at the development of peripheral and core European government bond yields over the past 10 years. As a proxy we used monthly generic 10 year yields for the largest economies in the periphery and the core (Italy and Germany, respectively). Again three phases are visible in the chart, but the transition from strong correlation to divergence occurred earlier, i.e., already in the wake of the Lehman collapse. At this point in time, due to their “safe haven” status German government bond yields declined faster than Italian yields. Both yields then trended downwards until the Eurozone crisis gained momentum, causing German yields to further decrease, whereas Italian yields peaked. Once again, Draghi’s publicly announced commitment to the Euro marked the turning point towards on-going core/periphery convergence.

Currently investors can earn an additional c. 170 bps when investing in 10 year Italian instead of 10 year German government bonds. This seems to be a decent yield pick-up, particularly when you compare it with the more than humble 18 bps of core/periphery IG spread differential mentioned above. As yield differentials have declined substantially from values beyond 450 bps over the past two years, the obvious question for bond investors at this point in time is: How low can you go? Well, the answer mainly depends on what the bond markets consider to be the appropriate reference period. If markets actually believe that the Eurozone crisis has been resolved once and for all, not much imagination is needed to expect yield differentials to disappear entirely, just like in the first phase in the chart above. When looking at the past 10 years as a reference period, there seems to be indeed some headroom left for further convergence as the current yield differential ranks high within the third quartile (69th percentile). However, if bond markets consider future flare-ups of Eurozone turbulences a realistic scenario, the past 5 years would probably provide a more suitable reference period. In this case, the current spread differential appears less generous, falling into the second quartile (39th percentile). The latter reading does not seem to reflect the prevailing market sentiment, though, as indicated by unabated yield convergence over the past months.

In summary, a large portion of peripheral to core European risk premiums have already been reaped, making current valuations of peripheral debt distinctly less attractive than two years ago. Compared to IG credit spreads, there seems to be more value in government bond yields, both in terms of current core/periphery differentials and regarding the potential for future relative outperformance of peripheral vs. core debt due to progressive convergence. But, of course, on-going convergence would require bond markets to keep believing that the Eurozone crisis is indeed ancient history.

World Cup currency trading strategies: emerging vs. developed markets

Posted on 14 April 2014 by Claudia Calich

With just under two months to go to the opening match and tensions already mounting within our team (we have 8 different participating countries covered – Australia, Brazil, England, France, Germany, Italy, Spain and USA), we thought it was time for a World Cup themed blog. Our prior predictor of the 2010 World Cup winner proved to be perfectly off the mark. Based on expected growth rates in 2010, we predicted that Ghana would win and Spain would come last – and we know what happened subsequently. However, in defence of the IMF, Ghana were the surprise package of 2010, only failing to reach the semis thanks to a Luis Suarez handball.

However, despite the tradition of ‘lies, damned lies, and statistics’, I still believe in analysing data and making predictions. Was it coincidence that the team that was not part of our predictions (North Korea), given the lack of available economic data, ranked last? Would Argentina have made it to the quarter-finals had it not been altering its inflation statistics?

Historically, the World Cup has been won 9 times by an emerging country and 10 times by a developed country. Will an emerging country win and tie the score this year?
We present two currency trading strategies associated with the World Cup:

Arbitrage: in currencies with full convertibility or minimal transaction costs, arbitrage opportunities are very limited. However, currencies that are subject to restrictions on capital flows, taxation or regulatory requirements often offer arbitrage opportunities in excess of the costs associated with these factors. For example, for the World Cup in Brazil, ticket prices for non-residents are determined in USD and in BRL for Brazilian residents. Ticket prices were set by FIFA in May 2013 (1980 Brazilian Reals or 990 US Dollars for category 1 tickets), based on the prevailing US Dollar / Brazilian Real exchange rate of 2.00. As ticket prices remain unchanged in USD and BRL and given the depreciation of the Real since then, ticket prices in BRL are now 14% cheaper than tickets purchased in USD.¹
Currency carry trades: a popular strategy which is relatively easy to implement and which has proven profitable². We test the strategy by going long a basket of emerging market currencies of the qualifying countries (which are normally higher yielding due to higher inflation, economic risks, etc.) funded by a basket of developed market currencies of the qualifying countries (which are normally lower yielding, which has been exacerbated by quantitative easing). Out of the countries that qualified for the recent World Cups, we arbitrarily classify them as 18 emerging and 14 developed. However, if we measure them by currency, the numbers change slightly. A few emerging countries have a developed market currency as legal tender (for example, Ecuador adopted the US Dollar as its legal tender in 2000), so it makes sense to count them as developed countries. We keep Ivory Coast under the emerging basket, as the West CFA Franc, while pegged to the Euro, is not the same as having Euro as its legal tender.

We test our World Cup carry trade performance during the last 2 World Cups between January 1 (a clean start date once the 32 qualifying teams became known) and the start dates for each tournament.

The EM vs DM FX carry trade posted a small profit in 2006 (+0.4%) and was a clear winner in 2010 (+2.4%)³ . On the football field, however, emerging market lost to developed market in both instances (Italy and Spain won). Ahead of the upcoming cup, the carry total return points to a loss on the EM carry trade so far (-2.8% to the 11th of April). On this basis, I predict that an EM team will win the cup in Brazil.

¹For a more complex example of score betting on World Cups, see http://elsa.berkeley.edu/~botond/szjrt.pdf.
²For an empirical discussion of emerging market carry trades, see http://www.nber.org/papers/w12916.pdf?new_window=1.
³For simplicity reasons, we have omitted bid-offer transaction costs from the calculations. Given that some of the smaller EM currencies are less liquid and have higher costs (in this case, one buy and subsequent sell), the results slightly overstate the returns of the EM long side. On the short side, we only included the Euro once, to maintain a “diversified” basket of developed currencies.

5 Signs That the Bond Markets (rightly or wrongly) think the Eurozone Crisis is Over

Posted on 10 April 2014 by James Tomlins

Regardless of your opinion on the merit of the ECB’s policy, there is little doubt that the efficacy of Mario Draghi’s various statements and comments over the past 2 years has been radical. Indeed there are several signs in the bond markets that investors believe the crisis is over. Here are some examples:

1) Spanish 10 yr yields have fallen to 3.2%, this is lower than at any time since 2006, well before the crisis hit, having peaked at around 6.9% in 2012. This is an impressive recovery, almost as impressive as …

2) The fall in Italian 10 year bond yields, which have hit new 10 year lows of 3.15%, lower than any time since 2000. The peak was 7.1% in December 2011. To put this in context, US 10 year yields were at 3% as recently as January this year.

3) Last month, Bank of Ireland issued €750m of covered bonds (bonds backed by a collateral pool of mortgages), maturing in 2019 with a coupon of 1.75%. These bonds now trade above par, with a yield to maturity of 1.5%. The market is not pricing in any material risk premium relating to the Irish housing market.

4) There is no longer any risk premium within the high yield market for peripheral European risk. The chart below (published by Bank of America Merrill Lynch) shows that investors in non-investment grade corporates no longer discriminates between “core” and “peripheral” credits when it comes to credit spreads.

5) Probably the biggest sign of all, is that today Greece is re-entering the international bonds markets. The country is expected to issue €3bn 5 year notes with a yield to maturity of 4.95%.

The power of duration: a contemporary example

Posted on 4 April 2014 by Matthew Russell

In last year’s Panoramic: The Power of Duration, I used the experience of the US bond market in 1994 to examine the impact that duration can have in a time of sharply rising yields. By way of a quick refresher: in 1994, an improving economy spurred the Fed to increase interest rates multiple times, leading to a period that came to be known as the great bond massacre.

I frequently use this example to demonstrate the importance of managing interest rate risk in fixed income markets today. In an investment grade corporate bond fund with no currency positions, yield movements (and hence the fund’s duration) will overshadow moves in credit spreads. In other words you can be the best stock picker in the world but if you get your duration call wrong, all that good work will be undone.

We now have a contemporary example of the effects of higher yields on different fixed income asset classes. In May last year Ben Bernanke, then Chairman of the Fed, gave a speech in which he mentioned that the Bank’s Board of Governors may begin to think about reducing the level of assets it was purchasing each month through its QE programme. From this point until the end of 2013, 10 year US Treasuries and 10 year gilts both sold off by around 100bps.

How did this 1% rise in yields affect fixed income investments? Well, as the chart below shows, it really depended on the inherent duration of each asset class. Using indices as a proxy for the various asset classes, we can see that those with higher durations (represented by the orange bars) performed poorly relative to their short duration corporate counterparts, which actually delivered a positive return (represented by the green bars).

While this is true for both the US dollar and sterling markets, longer dated European indices didn’t perform as poorly over the period. There’s a simple reason for this – bunds have been decoupling from gilts and Treasuries, due to the increasing likelihood that the eurozone may be looking at its own form of monetary stimulus in the months to come. As a result, the yield on the 10-year bund rose by only 0.5% in the second half of 2013.

Whatever your view on if, when, and how sharply monetary policy will be tightened, fixed income investors should always be mindful of their exposure to duration at both a bond and fund level.

The emerging markets rebalancing act

Posted on 2 April 2014 by Claudia Calich

Over the past year, investors’ perception towards emerging market bonds changed from viewing the glass as being half full to half empty. The pricing-in of US ‘tapering’ and higher US Treasury yields largely drove this shift in sentiment due to concerns over sudden stops of capital flows and currency volatility. For sure, emerging market economies will need to adjust to lower capital flows, with this adjustment taking place on various fronts over several years.

Some emerging market countries are more advanced than others in the rebalancing process, while others may not need it at all. Also relevantly, the amount of rebalancing required should be assessed on a case-by-case basis, as the economic and political costs must be weighed against the potential benefits. Generally, the necessary actions include reducing external vulnerabilities such as large current account deficits (especially those financed by volatile capital flows), addressing hefty fiscal deficits and banking sector fragilities, or balancing the real economy between investment and credit and consumption.

In our latest issue of our Panoramic Outlook series, we examine the main channels of transmission, policy responses and asset price movements, as well as highlight the risks and opportunities we see in the asset class. Our focus in this analysis is on hard currency and local currency sovereign debt.

Stand up for your rights! Covenant erosion in high yield bond documentation

Posted on 1 April 2014 by James Tomlins

2013 saw a record year for new issue volumes in the European high yield market. A total of $106bn equivalent was raised by non-investment grade companies according to data from Moodys. Whilst this is beneficial for the long term diversification and growth of the market, there have been some negative trends. Given the intense demand for new issues, companies and their advisors have been able to perpetuate the erosion various bondholder rights to their own advantage. What form has this erosion taken and why are they potentially so costly for bondholders? Here we highlight some of the specific changes that have crept into bond documentation over the past 2 years and some examples that demonstrate the potential economic impact for investors.

1) Shorter call periods – high yield bonds often contain embedded call options which enable the issuer to repay the bonds at a certain price at a certain point in the future. The benefit for the issuer is that if their business performs well and becomes less financially risky, they can call their bonds early and re-finance at a cheaper rate. The quid pro quo for bond holders is that the call price is typically several percentage points above par, hence they share in some of the upside. However, the length of time until the next call is important too. The longer the period, the higher the potential capital return for any bond holder as the risk premium (credit spread falls). The shorter the call period, the less likely the issuer will be locked into paying a high coupon. Take for example the situation below: reducing the call period has an associated cost to the investor of 2.6% of capital appreciation.

2) 10% call per year at 103 – Similar to the example above, the ability to call a bond prior to maturity has the impact of reducing potential upside to investors. One innovation that favours issuers has been the introduction of a call of 10% of the issue size every year within the so called “non call” period, usually at a preset price of 103% of par. So assuming a 3 year “non call” period, almost 1/3rd of an issuers bond can be retired at a relatively limited premium to par. Take for example the counterfactual scenario below. Here we see the inclusion of this extra call provision has reduced the potential return to bondholders by 3.3% over the holding period.

3) Portability – One of the most powerful bondholder protections is the so called “put on change of control”. This gives the bondholder the right but not the obligation to sell their bonds back to the issuer at 101% of face value in the event the company changes ownership. Crucially, this protects investors from the potential re-pricing downside of the issuer being purchased by a more leveraged or riskier entity. For the owners of companies, this has been a troublesome restriction as the need to refinance a complete capital structure can be a major impediment to any M&A transaction. However, a recent innovation has been to introduce a “portability” clause into the change of control language. This typically states that subject to a leverage test and time restriction, the put on change of control does not apply (and hence the bonds in issue become “portable”, travelling with the company to any new owner removing the need to potentially re-finance the debt). With much of the market trading well above 101% of par, the value of the put on change of control is somewhat diminished so some investors have not seen this as an egregious erosion of rights. The owners of the issuers on the other hand enjoy a much higher degree of flexibility when it comes to buying and selling companies. There are costs to bondholders, however. In particular, as and when bonds trade below face value, this option can have significant value. In the example below we see that the inclusion of portability has an associated cost of 2.4%

4) Conditional Restricted Payment Basket – Another protection for high yield bondholders has been the restrictions on dividends. This prevents owners of businesses from stripping out large amounts of cash leaving behind a more leveraged and riskier balance sheet. If a company was performing very well and the owners wished to take out a large dividend, they would usually be forced to re-finance the debt or come to a consensual agreement with bondholders to allow them to do so. Consequently, the call protections would apply and the bondholders would be able to share in some of the success of the issuer’s business. However, another recent innovation has been the loosening of this “restricted payments” provision to allow a limitless upstreaming of dividend cash out of the business subject to a leverage test. This limits the ability of owners to load up the balance sheet with debt at will, but without the need to re-finance the bonds bondholders loose some of their bargaining power and once more are likely to lose out in certain situations. In this example, we see an impact of 1.0%

What can investors do to cope with these unwelcome changes? Some sort of collective resistance would probably be the most effective tool – bondholders need to be prepared to stand up for their rights – but this is difficult to maintain in the face of inflows into the asset class and the need to invest cash. Until the market becomes weaker and negotiating power swings back toward the buyers of debt rather than the issuers, the most pragmatic course of action is for investors to asses any change on a case by case basis, then factor these in to their return requirements. This way investors can at least demand the appropriate risk premium for these changes and if they deem the risk premium insufficient they can simply elect to abstain. In the meantime, the old adage holds as true as ever – caveat emptor.

The UK electoral cycle is alive and kicking

Posted on 20 March 2014 by Richard Woolnough

Yesterday’s UK Budget had one major surprise, the relaxation of rules regarding drawing down your pension. This means that from April 2015 you can draw down your pension pot in one go, to do with it as you wish. This policy move chimes with the coalition’s beliefs that one should take responsibility over one’s own finances. However, like all political decisions there may well be an ulterior motive behind the timing of this decision.

We talked previously about why a dovish central banker appointment at the Bank of England was politically expedient two years ahead of the May 2015 election. The current government had its last opportunity yesterday to add a last feel-good give away Budget to enhance the economy and its own electoral prospects. At first glance, what has it achieved with its surprise change in pension policy?

It has potentially released a huge wave of spending commencing April 2015. This will obviously make people feel wealthy as the cash literally becomes theirs as opposed to being locked away for a rainy day. The economic effect looks as though it would be too late to boost the economy ahead of the 2015 general election. However it is highly likely that the forthcoming pension pot release will be taken into account. Holidays would be booked ahead of the windfall, cars could be purchased, redecorating done, and Christmas presents bought as the promise of money tomorrow means you can run down saving and consume today. This pension release scheme will spur growth in the UK ahead of the election.

The particular neat trick of this policy change is that it is a giveaway Budget measure at no cost. This is because it is not the government giving away money, but it is simply giving people access to their own money. Fiscal stimulus at no cost, combined with low rates and a strong government sponsored housing market means the UK will continue to have a relatively strong economy.

Seeking relative value in USD, EUR and GBP corporate bonds

Posted on 20 March 2014 by Wolfgang Bauer

In terms of investment grade credit, it has been a common theme for global fixed income investors to think of EUR denominated credit as relatively expensive versus USD credit. Conversely, many see GBP corporate bonds as relatively cheap. But can it really be as simple and clear-cut as this? To answer this question, I have compared monthly asset swap (ASW) spreads of IG credit, issued in these three currencies, both on an absolute spread and a relative spread differential (EUR vs. USD and GBP vs. USD) basis.

At first, I looked at the three BoAML corporate master indices for publicly issued IG debt, denominated in USD, EUR and GBP. As shown below, until the onset of the financial crisis in the middle of 2007, USD IG credit was trading at spread levels of around 50 bps, which is almost exactly in line with GBP and on average only 15 bps wider than EUR IG credit. During the financial crisis, USD spreads widened more dramatically than EUR and GBP spreads. At peak levels in November 2008, when USD spreads reached 485 bps, EUR and GBP credit spreads were significantly tighter (by 215 bps and 123 bps, respectively). Subsequently, GBP IG spreads surpassed USD spreads again in May 2009 and have been wider ever since.

In contrast, EUR IG credit spreads have been consistently tighter than USD spreads. Even at the height of the Eurozone crisis in late 2011, the EUR vs. USD credit spread differential was negative, if only marginally. Over the past three years, USD IG credit has been trading on average at a spread level of 166 bps, i.e., nearly 30 bps wider than EUR IG credit (137 bps average spread) and c. 50 bps tighter than GBP IG credit (215 bps average spread). Hence, when only looking at an IG corporate master index level, it is justified to say that subsequent to the financial crisis EUR credit has been looking relatively expensive and GBP credit relatively cheap compared to USD credit.

Taking only headline master index spreads into consideration is an overly simplistic approach. A direct comparison between the USD, EUR and GBP corporate master indices is distorted by two main factors: index duration and credit rating composition. As shown below, there are substantial differences in terms of effective index duration between the three master indices. Over the past ten years, the effective duration of the USD master index has been on average 6.2, whereas the EUR and the GBP indices exhibited values of 4.4 and 7.3, respectively. Currently, index duration differentials account for -2.1 (EUR vs. USD) and 1.4 (GBP vs. USD).

These significant deviations in duration, and thus sensitivity of bond prices towards changes in interest rate, render a like-for-like index comparison problematic. The same applies to differences in credit rating composition. Take, for example, the rating structures of the USD and the EUR master indices in March 2010. Whereas the USD index hardly contained any AAA (below 1%) and only c. 18% AA rated bonds, the EUR index comprised nearly 6% AAA and c. 26% AA bonds. In contrast, the ratio of BBB bonds was significantly higher in the USD index (almost 40%) than in the EUR index (c. 22%). The credit quality on that date was distinctly higher for the EUR index than for the USD index, and directly comparing both indices would therefore be a bit like comparing apples to… well, not necessarily oranges but maybe overripe apples, for lack of a more imaginative metaphor.

Duration and credit rating biases can be removed from the analysis – or at least materially reduced – by using bond indices with narrow maturity and credit rating bands. As an example, I plotted relative spread differentials (i.e., EUR vs. USD and GBP vs. USD) for the past 10 years, based on the respective BoAML 5-10 year BBB corporate indices. To add another layer of complexity, this time I did not use headline corporate index level spreads but differentiated between financials and industrials instead. As only relative spread differences are shown, positive values indicate relatively cheap credit versus USD credit and, conversely, negative values signal relatively expensive credit.

Until October 2010, the graphs follow a very similar path, EUR and GBP credit spreads trade fairly in line with USD spreads up to the financial crisis, when USD spreads widen more strongly than both EUR and GBP spreads, pushing spread differentials temporarily into deeply negative territory (below -220 bps in the case of financials). Then things got more interesting as spread differentials seem to decouple to a certain extent from October 2010 onwards. At this level of granularity it becomes clear that it is an inaccurate generalisation to refer to EUR credit as expensive and GBP credit as cheap versus USD credit.

In terms of 5-10 year BBB credit, EUR financials have in fact been trading consistently wider than USD financials, although the spread difference has been falling considerably from its peak Eurozone crisis level of 201 bps in November 2011 to currently only 10 bps. EUR industrials have been looking more expensive than USD industrials since early 2007 (c. 35 bps tighter on average over the past 3 years). The trajectory of GBP financials spread differentials has been broadly following the EUR financials’ humped pattern since late 2010, rising steeply to a maximum value of 259 bps in May 2012 and subsequently falling to current values at around 115 bps. GBP industrials have been looking moderately cheap compared to USD industrials since late 2010 (c. 37 bps wider on average over the past 3 years), but the spread differential has recently vanished. Hence, regarding 5-10 year BBB credit, currently only GBP financials are looking cheap and EUR industrials expensive versus the respective USD credit categories, whereas GBP industrials and EUR financials are trading in-line with USD credit.

To sum things up, when comparing USD, EUR and GBP IG credit, headline spreads are merely broad-brush indicators. To get a greater understanding of true relative value, it is worth analysing more granular data subsets to understand the underlying dynamics and the evolution of relative credit spread differences.

The M&G Central Bank Credibility Survey – the Carney impact?

Posted on 17 March 2014 by Jim Leaviss

Whilst YouGov is surveying consumers around the UK, Europe and Asia for the M&G YouGov Inflation Expectations Survey, we thought it would be useful for them also ask some questions about how people perceive both their central bank’s ability to hit the inflation target, and the likely effectiveness of government fiscal policy. You probably won’t be surprised to hear that Europeans generally don’t think highly of the ECB or their politicians (although France is striking in its low levels of confidence in both, reflecting a degree of economic stagnation there, even as other areas of the Eurozone see signs of recovery). But it’s the UK that’s seen the biggest improvement in sentiment towards its central bank, the Bank of England.

Mark Carney was announced as the 120^th Governor of the Bank of England at the end of November 2012, at the start of our first survey quarter. At the time, only 28% of the 2000+ people surveyed who had a view (stripping out “don’t knows”) were confident that the “central bank is currently pursuing the correct policies in order to meet its target of price stability (i.e. inflation around 2%) over the medium term (i.e. the next 3-5 years)”. Our latest survey shows that in every quarter since then – and Mark Carney arrived at his desk on 1 July 2013 – this percentage has increased. The latest quarter shows the biggest increase yet, with 55% of respondents confident that the Bank is following the right policies to achieve medium term price stability.

And this is against a backdrop of a fair few raspberries about the Bank’s forward guidance regime (gilt yields tended to rise, and the pound strengthened every time Carney did some more communicating). So why the almost doubling in the confidence in the Bank of England amongst the UK population? Well, it’s the economy. The UK has been one of the developed world’s fastest growing economies over the past year, with GDP growth at 2.7% year on year, after a couple of years where it felt as if it would be stuck at or below 1% forever. Crucially when it comes to thinking about credibility, for the very first time since the depths of the financial crisis in 2009, CPI inflation is back below the Bank of England’s 2% inflation target. At one point in 2011 CPI was running at over 5% year on year. And whilst real wages are still falling, nominal wages have started to perk up in the past few months, so the hit to workers’ pay is lessening.

Our survey isn’t the only measure that shows that the Bank of England’s credibility is strong and improving. Central banks like to use index linked bonds to derive a market participant view of whether inflation expectations are anchored. Remembering that UK index linked gilts are priced from RPI rather than CPI, and that estimates are that the long term “wedge” between the two measures is somewhere around 1.1% over the medium term (it could be higher in a rate rising environment as RPI contains a big chunk of mortgage interest payments). The current 5 year 5 year forward breakeven inflation rate – the market’s price for average inflation over the five years from 2019 to 2024, i.e. taking out the current cycle and looking at a medium term expectation for inflation – stands at 3.35%, down from 3.65% at the end of November last year. If you subtract the wedge you end up with a market CPI inflation forecast of 2.25% over the medium term. This is a little above target, but given the Bank’s history in recent years of large upside misses, could reflect improving credibility. It should be said however that this measure has generally been pretty stable (5 year average of 3.5%) so it doesn’t feel as if there is a significant signal on King Bank versus Carney Bank credibility here.

You can see the full M&G YouGov Inflation Expectations Survey here, and the M&G Central Bank Credibility Survey is within that report on page 6.

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