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Friday 29 March 2024

The Fed remains hawkish relative to the market, once again stating that rates are going higher than markets have priced, and that rates will stay there for longer than priced, so as to bring inflation back down ‘towards 2%’. It expects growth to be lower, and it expects inflation and unemployment to be higher than it previously expected. In short, recent moves lower in yields and risk premia are loosening financial conditions and this may well require, in the Fed’s eyes, tighter policy for longer.

How can we interpret this and invest with this?

We all have to admit, as the Fed has started to emphasise in recent meetings, that we are all in a blind spot economically. No one knows how and when the tightening in monetary policy that has been undertaken in 2022 will really start to impact the real economy, nor to what extent. It will, as the Fed states, bring growth down and unemployment up. But the key here for all central banks is inflation. The tightening in policy rates will bring inflation down, as will base effects and continued recovery of global supply chains.

Source: Bloomberg, 30 November 2022

Is the tightening so far enough?

The essential question for markets though, is whether the tightening that has occurred and the slowdown that results will bring inflation down to 2-3% (where my hunch is central bankers the world over would be happy), or to a higher level of 3% plus. No one can know this in 2022, and perhaps not in 2023 either. The determining factor in all of this, and the major hurdle around the world for inflation to return to target, is the labour market. Labour markets are too strong for inflation at 2%: simply put, wage growth at 5-6% is incompatible with inflation at 2% target. Wages need to be at half these levels for the target to come into sight. At this moment in time, and with labourers this agitated for inflation-chasing wage rounds, I will not be positioning for a return to on target inflation.

Source: Bloomberg, 30 September 2022

However, as the monetary policy time lag passes and as we therefore observe the extent to which the labour market and wages react to the interest rate tightening we have seen this year, markets will be in a better position to evaluate the destination for inflation. We cannot know this now, and nor can the Fed. All they can tell us is that they are determined to bring inflation back down ‘towards 2%’, and that this might take higher rates for longer than markets expect. Why? Because they do not know how these currently strong labour markets will react and how long it will take to get wages down to levels that are consistent with near target inflation.

Inflation in 2023

My guess, in line with what seems to be consensus, is that we are now clearly facing a period in which inflation falls, and falls sharply. I think it is perfectly possible that in the next 6 months or so we see inflation in the US fall from 7% to 3-5%. And we might see UK and EU inflation fall from 11% to 4-6%. This will be a powerful and rapid move lower in inflation, and bonds will start to look (as indeed they already have) much better value as a result. Much more interesting will be what happens in the second half of 2023 and into 2024. Will the labour markets have weakened enough that public and private sector employers are facing down their workforces and taking wage growth to the required levels? Or will they remain strong and will wage rounds stay at elevated levels? If that’s the case, then as the Fed told us this week, rates will have to go higher than expected and stay there for longer than expected. But today, no one knows: not the markets (which are predicting a big hit to jobs markets to come imminently), nor the Fed (which is clearly concerned about the continued strength).

What area of bond markets should we be most focussed on as we head into 2023 and 2024? Well, if inflation is going back to target fast, I would be most focussed on long dated government bonds where yields are at around 3.5% in the US and UK and at around 2% in Europe. In the US and UK, if inflation is going back to 2%, then buying these bonds offers a real yield of 1.5%, and in Europe long dated bunds offer a real yield of around 0%. But if labour markets are too strong for this journey downwards in inflation to reach 2%, or if central banks show that in light of the economic slowdowns likely to come in the next two years and that they are happy with inflation to fall to 3-4% before they stop tightening in search of on target inflation, then I would be much less inclined to be buying long dated bonds at these yield levels. So, for now I will admit, like the Fed, that I do not know where inflation is going to end up in 2023 or 2024, other than lower than it is today. And like the Fed, we are all data dependent and need to watch economic developments and particularly labour markets, before we position our portfolios based on the final destination of inflation.

Summary: This morning’s release of UK inflation data saw a significant surprise to the upside relative to expectations, with headline CPI rising from 1.3% to 2.1% year on year, and RPI rising from 2.9% to 3.3%. Whilst much of this jump will of course, but justifiably, be put down to transient factors (energy, fuel, transport, hotels, clothing, package holidays, and restaurants), it should cause investors to question whether all of the upward pressure is temporary, or whether once the transient factors subside, inflation will be left at an elevated rate.

Warnings signs of longer-lasting inflation are starting to build: core CPI (which excludes fuel, alcohol and tobacco) rose from 1.3% to 2%, and wages released yesterday (along with a raft of other pretty strong employment data) rose to levels well above 5% higher than year ago numbers. We will continue to watch core inflation and particularly wages for giving indications around whether inflation will prove to be more lasting than many believe. Wage cycles are long lasting, and can become self-fulfilling via inflation expectations more broadly, and this will be key.

In terms of how the markets are set up presently, observing levels of nominal bond yields globally suggests that markets are of the same view as the Federal Reserve, namely that the vast majority of higher inflation prints at the moment will prove shortly to be transient. However, looking at nominal yields is too narrow a view: breakevens in the UK and US (and even Europe) have been on a sustained rise for more than a year now, and in the US and UK show that index linked bond investors are concerned about inflation being above ‘targets’ (whatever that now is in the US under AIT, and whatever the wedge turns out to be post RPI reform in 2030 in the UK) for as far as the eye can see. This is clearly demonstrated by US breakevens being above 2.5% at 5yrs and at 2.4% at 30yrs, and by UK breakevens being at 3.4% for 5yrs and 3.4% for 50yrs. As for why the nominal yield markets appear to be pricing so benign an inflation outlook, whilst inflation markets appear to be pricing in a sustained and meaningful overshoot to inflation targets? Well, QE continues apace which supports nominal yields. Deeply negative real yields feels likely to be a completely desirable and long term policy outcome for central bankers. And ultimately, if nominal yields rise too far (whether on the grounds of inflation concerns or otherwise), with such historically high levels of government indebtedness, the central banks are likely to keep suppressing yields via QE and other policies for many years to come.

Source: M&G, Bloomberg, 16 June 2021

Strategically, given the likelihood of continued central bank support of nominal yields, and inflation prints that are starting to appear as though they may be more sustainably above target levels than they have been for a very long time, I think it still makes sense, long term, to own real yields. If nominals are supported and inflation stays sticky, real yields are a good thing to own. More tactically, though, with breakevens at pretty elevated levels across all maturities, it feels to me to be more likely than not, that we see a rise in real yields. This could be either because inflation outcomes start to fall back, bringing breakevens with them (and so real yields higher). It could just as well be because nominal yields rise, pulling real yields with them. It is always worth remembering that the hugely dominant driver of real yields remains nominal yields. For this reason, as we head through peak base effects and peak growth over the next few quarters, investors should be thinking more closely about limiting the effects from rises in real yields. But that time has not come yet, and the wind feels very much in the sails of inflation in the here and now.

The principle risk to yields at the moment, and therefore real yields too, is central banks. Any hawkish turn could see a step higher in yields. This should also put something of a dampener on breakevens, which would see real yields underperform nominals. However, if this is not imminent, super accommodative monetary (and fiscal) policy will likely see economic data continue to be strong, and will see inflation expectations build further from here, and so real yields remain supported or perhaps even move lower.

The background to Wednesday’s announcement

In line with market consensus, on Wednesday the government announced that RPI would be made into CPIH, a lower number. This is not being done for political reasons by the Chancellor, but for statistical ones.

As I have written about previously the national statistician has made clear for years that it does not like RPI, and that it has been frustrated at being unable to reform the methodology around its calculations (to make it a lower, more accurate reflection of inflation) because of the need to get approval from the Chancellor. It is worth remembering that the statistician consulted on abolishing RPI in 2012, and has since de-recognised it as a national statistic as it does not see it as fit for purpose. The statistician gets control of the issue when the UK 4.125% 2030 linker matures.  In this way the government can present the decision as a passive one, made by the statistician and not the Chancellor.

The decision

This announcement makes clear, at long last, that RPI will be the same number as CPIH from 2030 onwards. This number will be approximately 0.8 percentage points lower over the medium term than it is in under its present calculation. If we assume that nominal gilt yields are unaffected by this, it means that RPI breakevens will need to fall by around this amount from 2030 onwards. That means that real yields need to rise, and breakevens to fall, by around 0.8 from 2030 onwards.  The government announcement says in bold “The government will not offer compensation to the holders of index-linked gilts”.

Market impact

Given that the market expected this outcome by and large, why did we see meaningful moves in linkers and breakevens on Wednesday? And are they moving as we would expect, given the above?

The biggest increases in breakevens are being seen in the 5y to 10yr part of the curve (yellow line below). This is because there was significant nervousness that, given the huge borrowing brought on by the pandemic and the dire state of the fiscal deficit, the Chancellor might be prepared to make this reform political and accelerate its implementation date to 2025. On Wednesday he announced he would not do that, and so the bonds in this part of the curve are rallying.

Secondly, and most striking to me: longer dated breakevens and real yield are not selling off massively but are in fact rallying.  The fact that the market was expecting this outcome, with breakevens having started to move somewhat lower in recent times to reflect this, does not even start to explain this: the market is moving in a counter-intuitive way and counter to what I would expect. Breakevens shouldn’t be moving significantly higher, but should be moving lower, perhaps by 50bps to 70bps. Clearly there’s a long time left before the longer-dated bonds mature, with lots of inflation cycles and potentially much higher inflation to come in the future, maybe even with CPIH being between 2.75% and 3%. But given Wednesday’s news, and the disinflationary spot we still find ourselves in, the pricing of breakevens now looks on the expensive side to me.

Maybe some think that they will be able to claim compensation for the change from the government? We found out on Wednesday that none will be paid. Perhaps some will try to litigate? Given the changes are statistical, not political, I think this is a pipe dream too. Perhaps the market was waiting for a weak day to buy inflation protection and lots of traders pressed the button on Wednesday?  There is plenty of appetite for linkers from pension funds, and those which were underhedged on inflation will have seen their funding ratios increase.  Perhaps that is the best explanation for the rally: with limited inflation-linked issuance, they have not hung around.  And there may be plenty of less-price-sensitive, liability-driven funds too which were short of breakevens and, with the RPI uncertainty removed, have now moved in.  Still, I would not have expected this demand to come so early: I anticipated a significant downward repricing first. 

There is also the possibility that the market is pricing in a more bullish view on the housing market, which is currently very strong, and that this is leading to a higher outlook for CPIH.  Even so, the moves on Wednesday were surprising and make UK breakevens look on the expensive side for now – that is, until it becomes clear that we are in a cyclical upturn, with loose monetary policy and continued loose fiscal policy, and perhaps a new average inflation targeting regime.

So, the changes to make RPI a lower number have been approved, to come into effect as anticipated by most in 2030. This should, fundamentally, lead to higher real yields and lower breakevens post implementation. In the long end, I would have anticipated fairly significant moves on Wednesday, in the exact opposite direction from those which we saw.

Inflation valuations

There are plenty of factors in the mix to make me bullish on a medium-term reflation scenario in the UK: this time round, we have fiscal and monetary policy working together to stimulate the economy (unlike in the aftermath of the GFC, when policies of austerity led to a fiscal tightening); given the country’s debt burden, it seems reasonable to expect central banks to allow inflation to run a little hot; and the risk of a weaker sterling after Brexit brings the possibility of further imported inflation.  Fundamentally though, it feels to me like inflation expectations both in swaps and in breakevens are on the rich side of fair value given that inflation is running low for now, and that the pandemic leaves us all in a more disinflationary spot than anything else, at least in the next 6 to 12 months. There is also a possibility of the return of austerity in 2021, which would risk a more persistent disinflation than the one we are in today.

I expect breakevens to cheapen up in the not too distant future, particularly if we see further linker supply in the next quarter, but anticipate some volatility.  Based on these valuations, I think there will be better opportunities to enter into the reflation trade then.  

We started 2019 with credit at levels we perceived to be pretty cheap. The run since then has been remarkable, with spreads today close to all-time lows. What should one be doing with credit risk at this point?

There are reasons to remain bullish on credit, and fully invested. First, we remain in a goldilocks economic environment for bonds, with low growth and low inflation. These economic climes tend to be the very ones in which credit, particularly investment grade credit, performs well. Likewise, fears of imminent recession appear to be declining in the US and UK, while in many other parts of the world economic growth continues relatively unthreatened. The onset of recession tends to see credit spreads widen.

In investment grade credit, investors are overpaid structurally in spread based on historical default rates, and this remains true today (see chart below). Demographics and other factors have combined to mean that the bond market is in rude health technically, with a continuous wall of cash still finding its way into fixed income. Central bankers, contrary to the expectations of many (including the writer), have started 2020 once again on the dovish front foot, with policymakers at the Fed, ECB and BoE all talking about how much capacity they have to stimulate from today’s starting point of ultra-low rates and large back books of QE.

In terms of valuations, I guess one could say that spreads have been tighter, albeit only in very different circumstances many years ago and very briefly earlier this year and in Q1 2018. But the chart below shows where spreads are relative to their medians since 2006: Euro IG, GBP high quality (AA and A rated), and HY and IG CDS indices are all in the tightest 20% of their historical ranges. At the other end of things, the list of opportunities in which spreads are wider than their long-term medians has shrunk to US CCC HY, frontier market hard currency government bonds, and dollar denominated long dated BBBs. In the investment grade universe in which I am qualified to comment, we still see a number of attractive opportunities in long US BBB credit, even after the last few months of exceptional spread performance.

All in all, from this point I will be watching the credit market largely from the sidelines. I have watched spreads give up all their cheapness over the last 12 months and have sold bonds and names as I have thought they have become rich. Whilst I recognise the goldilocks economy we live in, and have reasonable confidence in the durability of this low inflation environment, I do not have as strong a view on growth on either side. There are reasons to be positive on the possibility that we see higher global growth, requiring policy tightening: we are seeing a bounce back in confidence after the UK election, and this may continue with any tailing off in the rate of spread of the coronavirus, the US election cycle, wage gains in much of the developed world, and an end to austerity (most presently in the UK). Then again, the virus’ spread has not yet reached plateau, Brexit uncertainty still looms large (and will do all year), ‘populist’ parties are still ascendant all over Europe, and central banks surely do not have huge flexibility to act on any of these growth-harming issues from here (which is presumably why they are all engaged in telling us how much room they have to loosen anyway).

To my mind, with spreads at these levels and economic conviction low, I am concerned about a problem primarily of valuation. The last time spreads were at these levels, we spent the rest of the year wishing we had sold more risk (2018) and we never got rising defaults or an economic recession. We just had a valuation rejection. Yes, investment grade credit spreads still overcompensate significantly relative to defaults, and with a wall of money coming into the market (another echo of 2018’s early weeks), we may well see spreads grind tighter for some months yet. But with the level of compensation on offer now so near all-time tights, and with so much uncertainty and noise around, I have said cheerio for now. There will surely be better opportunities to come.

As the year of the 325th anniversary of the Bank of England’s foundation, and as the month of one of the Bank’s more important rate-setting decisions since 2008, September provides a congruous occasion on which to reflect on the history of the BoE and consider what the future holds for it. Founded in 1694 as a private bank to the government, it was in 1998 that the BoE was granted independence from the government in setting monetary policy. Now the UK faces perhaps its greatest political uncertainty in a generation, it is worth asking the question: to what extent will this independence continue?

We have already seen the effect of populist leaders on central banks that are ostensibly independent. The obvious case is that of the US, but there are other examples to be found of central banks facing political pressure to keep monetary policy easy, from Turkish President Erdogan’s sacking of the then central bank governor, to the ECB’s reaction to persistently low growth in Europe. Even if Trump doesn’t control the Fed directly, he certainly controls the market, which in turn has forced the hand of the central bank and led to the Fed cutting rates with the economy in expansion. And with ever more monetary sweets to choose from in the jar, which politician could resist raiding the cupboard and giving their economy a sugar high of rate cuts, QE and lending?

Pressure on the Fed is likely only to increase as the 2020 elections approach: if President Trump is able to engineer further cuts, and then get the markets soaring with a trade deal and promises of tax cuts just in time for elections, we might begin to agree he is – in his words – “a very stable genius”.

For now the UK seems to have escaped the global disinflation which started in Japan and is now being seen in Europe. That fits the BoE’s line, which is that they plan to hike rates, irrespective of the outcome of Brexit. Mark Carney has even warned investors that they are underestimating how much interest rates could rise. Does the market believe him? It’s certainly not our base case: the strategy of hawkish language to prep the market for rate hikes evidently didn’t work for Jerome Powell. If the UK does leave the European Union on 31st October without a deal, UK growth is likely to suffer – if the BoE’s goal is financial stability, it would be hard to justify a rate hold, let alone hike. So far the BoE’s forecasts are based on the assumption of an orderly Brexit, but they have made no public change to this in light of the ever-growing likelihood of a hard exit.

Some investors argue that a lower sterling (inevitable in the event of a ‘no deal’ Brexit, and also likely if the BoE engages in quantitative easing) would lead to considerable imported inflation due to increased export demand. This would justify a hawkish policy response. Here, however, a direct parallel may be drawn with that which we have witnessed in the US this year. The data in the US (strong wages, low unemployment, a solid consumer) may well justify a continued hiking cycle, but with a nervous market which has been placated by the promise of monetary easing, would a rate hike really help economic stability? The Fed evidently asked themselves this question and didn’t think so. Unlike in the US, rate cuts are not priced in by the UK market so far: currently, the implied probability of no change at the next MPC meeting is close to 100%, while in the US the implied probability of another cut in September’s FOMC meeting is close to 100%. But in the event of a ‘no deal’ Brexit in a month’s time, market expectations going forward may well be very different.

There are other uncertainties which will follow Brexit. Many now expect a general election to take place shortly after 31st October. Would a Corbyn-led government follow a similar nationalization of governmental institutions as of infrastructure? It would certainly increase fiscal spend, leading to considerable debt issuance and downward pressure on gilt prices from increased supply. And given that higher interest rates promote the interests of asset-owners/lenders over borrowers, it is likely that such a government would seek to lower the cost of borrowing in any way possible.

And which rate should be thought of as “neutral” anyway? The 2% CPI target which the BoE follows has been changed in the past. In a post-Brexit world of potentially dampened growth prospects, it may be that this already fairly arbitrary number faces pressure. With low inflation and growth around the world, we would argue that it is fiscal policy which should concern itself with growth, and monetary with inflation.

For now the Bank of England continues to plough its lone furrow of hawkishness. But as the clock ticks down to 31st October and a hard Brexit seems ever more likely, it may be hard for the new BoE governor to avoid joining the loose money bandwagon.

Index-linked markets were sent into a tailspin yesterday as Chancellor Sajid Javid responded to an earlier letter from the UK Statistics Authority (UKSA), which had set out recommendations for the reform of the RPI. The longest-dated linkers (maturing in 2065 and 2068) fell by more than 9% as breakeven rates plummeted.

Javid’s response contained three big shocks for index-linked markets:

  • RPI to be aligned with CPIH – while Javid ruled out the possibility of RPI being scrapped, citing the potential disruption for the many users of RPI, he did appear to support the idea of fixing RPI by aligning its methodology with CPIH. Since CPIH is typically around 0.8% lower than RPI, this would of course have a significant impact on the future returns of index-linked gilts.
  • Changes could be phased in by 2025 – the letter also revealed that the changes to RPI could be brought forward to as early as 2025, potentially affecting a larger part of the index-linked market and over a longer timeframe than originally envisaged.
  • New risks for long-dated linkers – by far the biggest shock was the revelation that once all the old style linkers have matured in 2030, the statisticians are free to make any changes to RPI that they want, and without the prior approval from the Chancellor. While this critical point was stated in the statistician’s letter sent in March, incredibly this was not published. Investors have therefore been buying and continuing to own linkers maturing beyond 2030, completely blind to this fact.

Despite the extent of yesterday’s moves, it’s worth noting that breakeven rates yesterday only fell by between 10-15 bps. The wedge between RPI and CPIH, however, is around 80 bps, which means breakeven rates could potentially fall a lot further if RPI is eventually brought fully in line with CPIH. Following yesterday’s revelations, we now know there is nothing to stop the statistician from doing precisely this from 2030, once the UKTI 4.125% 2030 matures.

After a lengthy review, Britain’s House of Lords has finally said that the inflation index presently used to price inflation-linked securities, train fares or student loans should be replaced. Instead, the Consumer Price Index (CPI) should become the new benchmark, as it includes more items and has an overall higher credibility. So far, so good – except if you are an investor.

The statistics body has acknowledged the limitations of the currently used Retail Price Index (RPI), which has already been de-recognised as an official national statistic, but still, it would rather improve it. In any case, this is not a Lords vs ONS fight, as any change is ultimately in the hands of the Chancellor, who has had this issue on the table for a number of years.

We have discussed the difference between RPI and CPI (known as the “wedge”) many times before, but just as a reminder, RPI is generally higher not only because it is calculated using a different formula, but mainly because it contains a housing component (prices and mortgage interest payments), while CPI does not. Over the long term, and reflecting Britain’s booming housing market, RPI has been around 100 basis points (bps) higher than CPI.

What is the problem with this? For a long time, many have argued that this difference leads to “index shopping,” whereby expenditures gravitate towards the (lower) CPI, while revenues and income generally gain if linked to the higher RPI gauge. Index-linked gilts reference the RPI, the higher number, hence these securities immediately dropped when the upper House delivered its recommendation this week: linker (or inflation-linked bonds) yields spiked to their highest level since November, as seen in the chart below.

The House of Lords said that RPI should correct its 2011 calculation of clothing, a move aimed to reduce the price recognition of some items, but which has led to the opposite. This was an easy and obvious recommendation: was this calculation to change, RPI could fall by 25 bps or, according to some estimates, even 50 bps! All else remaining equal, the tweak would see breakeven rates (used as a proxy for inflation expectations) drop by 25-50 bps, making real yields take the pain (real yields rise as inflation expectations fall). In money terms: a 25-50 bps drop in RPI would see the price of the 2068 linker bond fall by 12% to almost a quarter!

More importantly, the House also recommended that new linker issuance should reference the CPI rather than the RPI. Five years ago, a consultation considered removing the RPI, but the implications of doing so were so severe that the commission in charge decided to stay put. Breakevens soared in relief. If this changes now and linkers end up referencing the CPI, and assuming a wedge of 100 bps, the price of the 2068 linker would almost halve.

Thankfully for investors, big regulatory changes in financial markets tend to be a bit more subtle: it is more likely that the Treasury announces an intention to issue CPI-linked bonds, which could co-exist with RPI-linked ones, while ceasing any new RPI-referenced issuance. This would still take a number of years, as preparations would be needed to prepare the market and to understand the implications. Following the Lords’ review and years of consideration, I am sure that the Chancellor and the Treasury are well aware that a simple switch from RPI to CPI might have a similar effect to the credit events so feared by investors – usually a negative change that diminishes an issuers’ capacity to repay debts. Bondholders would certainly lose – not a good thing for a country with a big current account deficit, something that makes it foreign-capital dependent.

All in all, I can only see rough times ahead as the wedge and CPI-referenced issuance are on the table. However, and in the short term, RPI-linkers might trade higher if issuance is ceased. Still, given the present rich valuations (breakevens are above 3% all along the curve), I expect more focus on the downside from here: if it is true that chances of a hard Brexit have diminished, one could expect a stronger pound limiting inflation growth. Still 12% below its level before 2016’s referendum, sterling has plenty of ground to make up – but that’s another story. Stay with us, I will come back with more comments as events unfold. They surely will.

Brexit caused a sharp decline in the value of the pound last week and has significantly increased expectations of higher inflation. The next few days could bring further moves – watch M&G fund manager Ben Lord discuss the potential scenarios and outcomes with Bond Vigilantes Editor Elena Moya.

After a decade dominated by extraordinary monetary stimulus that has kept interest rates and consumer prices at bay, the dog that didn’t bark is finally showing signs of life: inflation. As seen on the chart, both US and UK wage inflation have spiked in a tightening labour market – an old textbook recipe for further price increases to come. However, one has to look beyond the headlines to depict the real story – which I see as one of goldilocks and the bear.

Goldilocks – US:

The US economy continues to enjoy a goldilocks scenario, in which the economy is neither too hot to force a sharp rate tightening cycle, nor too cold to slow down corporate earnings. This backdrop allows companies to borrow at relatively low rates, helping them avoid defaults, at the same time that consumers do not lose too much purchasing power due to inflation. This is the dream scenario for many risk-on assets, such as High Yield, and has fuelled the US stock market to one record high after another. Happy days.

This economic sweet spot, however, could be derailed by the ongoing trade wars, which could well get worse before getting any better. While some forecasters say the trade dispute may lead to a slowdown and therefore, lower inflation, I do not share their view because:

  1. Imports become more expensive: tariffs may automatically increase the price of Chinese imports as Chinese manufacturers pass on the cost to US consumers, leading to higher prices.
  2. Substitution costs: If US consumers cannot or are unwilling to absorb higher prices, an automatic switch to US-made replacements may be easier said than done: building factories to increase domestic output may be challenging in the present rising rate environment, and also difficult as the US already has a very tight labour market. Trying to hire more workers when the unemployment rate is below 4% may lead to wage pressure, lifting inflation rather than reducing it.

Therefore, I see the Fed continuing to raise rates as planned and despite the recent dovish speech of Fed chair Jerome Powell in Jackson Hole in August.

The bear – UK: The picture is a bit cloudier in Britain, even if wage inflation surprised on the upside in July, reaching annualised growth of 2.9%, matching the March increase, and the highest level in 3 years. As shown on the chart, the optimism around UK inflation is not reflected in the market-implied future inflation rate, expressed by the breakeven rate:

Let’s look beyond the headlines to understand why:

  1. True driver: For once, the Bank of England (BOE) has been right in its forecast: Brexit will lead to higher wages as fewer foreign workers are lured to the country. With less competition, wages may continue to rise. This inflation push, however, might not be sustainable as it is not driven by strong economic output, but by supply and demand dynamics.
  2. Heat of the moment: General consumer prices came in above expectations in August, up an annualised 2.7%. They were largely driven by clothing, transport and even theatre prices. This happened in one of the hottest months on record, raising questions on whether this push is sustainable or not.
  3. Housing effect: Britons are enjoying the low rate environment to buy homes, but this could soon change if rates continue to increase. With half of mortgage payers being on a floating rate deal, just two rate hikes could significantly increase monthly payments, causing an economic slowdown and containing inflation. I already warned last year that poorly-timed interest rate hikes could be “overly myopic and pro-cyclical,” damping growth and inflation. Unfortunately, I was right: After the BOE raised rates in November, UK annualised growth fell to 1.2% in the first quarter of this year, the weakest pace since 2012.
  4. Unemployment – really that low? While the unemployment rate is at the lowest level since 1975, the figure may mask the fact that many Britons would like to work more and they don’t because they can’t. Anecdotally, car maker Jaguar Land Rover recently put its workers on a 3-day week until Christmas. Media reports have indicated that by 2020, the UK may have as many as 1 million agency workers – hardly a position for pay demands.
  5. Currency effect: Brexit uncertainty has continued to weigh on the pound this year, with sterling being down 2.6% against the US dollar since January  1st. This lifts the price of dollar-denominated imported products and, again, questions the sustainability of the inflation push as it may wane as soon as the base-effect disappears.

All the above leads me to think that, despite the recent increase in prices, inflation may end the year at the lower end of 2%, a level more reflective of Britain’s true – and more moderate – economic heartbeat. What could potentially challenge my inflation view? Brexit, of course, whose inflation outcomes seem as binary as the opinions that the subject draws. I envisage two scenarios:

  1. No inflation please, we are British: a last-minute compromise between Britain and the EU may strengthen the exchange rate up to 1.40 USD per pound, from the present 1.31. This would tame import price growth and contain wage demands, given the deeper integration with the EU.
  2. Cold Britannia: A hard, no-deal exit could push the exchange rate down to 1.20 USD per pound, a low reached in January 2017 after Prime Minister Theresa May said a no- deal Brexit was a possibility. This would trigger inflation and wage demands.

Which of these outcomes is more likely, depends on one’s views over Brexit. But, as far as inflation goes, the only thing that seems certain is that while in the US inflation is being generated by economic growth, in the UK it largely depends on the Brexit outcome – in which case, it may well end up being a bear. I hope to be wrong again.

The Financial Times today ran a story that the ONS has admitted errors in its measurement of the telecoms sector. It seems that the ONS has effectively been focussed on output of the telecom sector as based on turnover of the providers, and making a price assumption of the goods and services they sell. On this methodology, the ONS shows prices of telecoms were flat between 2010 and 2015, and turnover of the companies fell slightly, implying the real output of the industry was down 4% over the period. However, this approach fails to recognise huge changes in the quality of the goods and services sold. If prices stayed flat, then the telecom sector would have to be recognised as a productivity leader, similar to computers and computer components manufacturers, over the same period and for the same reasons.

However, if you try to adjust for the vastly improved quality of the hardware (which is surely seen to have improved faster than prices have risen) on the one hand, and on the data speeds and coverage on the other, then we have been in a productivity boom in this area for a number of years. And on top of that, the packages of data and texts and so on that people are now getting for a not dissimilar amount to before show that prices have plummeted on the services side. Putting this together, growth has been underestimated, productivity has been underestimated, and prices have been overstated.

Firstly to give the ONS their dues, this is remarkably similar to the issue that happened in the US in March 2017 when the statistician recognised the dominance of the ‘unlimited data package’ in the US (rather than pay as you go per unit of data up until then), and made a hedonic adjustment to telecoms services prices that bluntly was the single largest catalyst of the low US inflation story in 2017. Yes, larger in influence on US CPI than wages, which are indirect in their effect on CPI, and which were essentially flat in 2017. This will no longer be a negative drag when we get the April inflation data in the US, and is one of a plethora of reasons that may well account for the strong performance in recent months in US breakevens.

We are all used to seeing significant revisions to growth data, and particularly productivity data, and often over long and distant periods of the past. But CPI has never been backwardly revised since its introduction in 1996. It also raises a number of questions, such as what would happen to contracts that are linked to CPI (eg, pensions, pay), and would social security have to be reimbursed by people who were overpaid relative to revised, lower, CPI? These are surely too politically unpalatable to even consider? But if the changes were made from the point of revision to the data, there would then be a potentially large discontinuity between past CPI and present and future CPI. Would the Bank of England, for instance, at the point of revision, have to loosen policy aggressively so as to get new inflation up to 2%? But, in spite of these consequences of improving the data measurement, change for the better must occur. The question, for others, and for another time, is: how?

What might these changes to the inflation history of telecoms do to CPI? For this, as in many instances in the past, I have to turn gratefully as ever to Alan Clarke of Scotiabank, who pointed out the story to me this morning, and who had already run his own very rough numbers. Telephone equipment and services has a weight of 2.5% in CPI, so assuming 50% of that is services, and assuming that prices could be 35% to 90% lower in 2010-15 (as the FT article discusses), CPI could be 9bps to 23bps lower each year.

It may never happen, and if it does is likely not to be until at least 2019. Furthermore, the revisions are likely to only be made to CPI, as the ONS insists that RPI is ‘never revised’. This is important because holders of index-linked gilts earn RPI, not CPI, and the wedge (the amount RPI is from CPI, it can be lower as well as higher!) is assumed to be between 0.75% and 1%. If RPI isn’t changed, the wedge will have to be revised up to 0.85%-1.2%, and breakevens will move up, meaning linkers will outperform conventional gilts. RPI is already subject to criticism for being too high and antiquated, and this will not help matters. So, a slow burner, and one to watch. Mind you, we should recognise the difficulty in measuring this stuff. And perhaps if the quality and quantity adjustments were made properly to my shrinking soups and dry sandwiches around the City of London at the same time, inflation wouldn’t fall, it would actually rise!

 

Author: Ben Lord

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