ben_lord_100

Deflation spreading in Europe

The ECB has already demonstrated an unusually, and perhaps worryingly, high tolerance of low inflation readings, with no additional action having been taken despite Eurozone HICP at 0.5% year-on-year as inflation continues to fall in many countries.

(Dis)inflation

Why might this be? One reason might be that while it is very concerned about deflation, at this point in time the ECB does not have a clear idea of what the right tool is to relieve disinflationary pressure, or how to implement it. Another reason might be that it is not particularly concerned about the threat of disinflation and so is happy to wait for the numbers to rise.

With regards to the latter of these possibilities, Mario Draghi discussed the low inflation numbers in January in Davos as being part of a relative price adjustment between European economies, and as being an improvement in competitiveness. One implication from this argument has to be that the lowest inflation numbers are being seen only in the periphery, and that as a result the much needed price adjustment between periphery and core is starting to take place. The other implication from this argument is that the ECB is happy to let this adjustment happen.

The chart below, however, shows inflation in Germany, France, the Netherlands, Spain and Italy (which together make up around 80% of Eurozone GDP) in terms of constant tax rates on a headline basis. This is important because fiscal reforms can have significant impacts on inflation numbers, when perhaps these should be stripped out as being temporary and artificial. The most obvious example of this would be a country implementing a hike in VAT, in which case inflation will jump upwards for a period until the base effect is removed some time later. This chart, alarmingly, shows that Spain, Italy and the Netherlands are now all experiencing deflation on a constant tax basis. It also shows that France is close to the precipice, with inflation on this basis at 0.2% year on year.

(Dis)inflation at constant tax rates even worse

A further concern from the above two charts ties in to the ECB’s argument that the low inflation numbers in the periphery are a temporary phenomenon on a path to important and desirable internal adjustments to competitiveness. This argument might hold if the periphery is seeing low inflation, while the core is seeing stable, on-target or slightly above-target inflation that brings Eurozone inflation as a whole, to close to but below 2%. However, both the above charts show that the trend of disinflation is affecting more than just the periphery in isolation, and this calls Draghi’s competitiveness argument into serious question. The ECB might be well advised to get ahead of this worrying trend and act soon.

38814-bv-blog-avatar-male_200px

The Great Compression of peripheral to core European risk premiums

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).

Peripheral vs. core European non-financial IG credit

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.

Italian vs. German government bonds

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.

matt_russell_100

Opportunities in Spanish ABS

As fund managers it’s our job to take risk when and where we are being paid (preferably overpaid) to do so. One area where I feel that this is currently the case is European residential mortgage backed securities (RMBS), particularly Spanish RMBS.

It’s fairly easy to find senior Spanish RMBS trading as much as 100bps wide of equivalent covered bonds at the moment. The collateral in these deals was originated by the same banks as in the covereds, they return the principal over a comparable time horizon, and contain features that will be beneficial to investors if the Spanish housing market begins to weaken again.

The chart below shows this relationship nicely. Here we have plotted (minus the names of the individual bonds) short-dated covered bonds issued by three Spanish banks and what we consider to be similar quality senior RMBS. The pickup I mentioned earlier is clearly evident in the 2.5-5yr maturity/weighted-average life area:

Spanish RMBS blog

The main reason for this discrepancy is regulation. Financial regulators have deemed RMBS to be more risky than covered bonds and they therefore require banks and insurance companies to hold more capital on their balance sheets to compensate.

While I appreciate that covered bonds give investors dual recourse and that covered bond legislation in Spain is strong, I’m not sure how much the extra senior unsecured claim in a failed Spanish bank would actually be worth. Hence in general I prefer to hold a senior note in an RMBS deal where we have good visibility of the collateral, and which includes structural provisions that mean senior note holders potentially get their capital back sooner if the housing market deteriorates.

The ECB apparently takes the same view as the regulators and charges anyone wishing to use RMBS as collateral for repo transactions more than they do for covered bonds. They apply a haircut of 10% to RMBS but only 4.5-6% to covered bonds for investment grade quality instruments, assuming a five to seven year maturity. What I’m really saying is that I disagree with the regulators, and therefore see this as an opportunity to generate a higher return for a similar level of risk.

Interestingly the Bank of England applies the same haircut of 12-15% to both short-dated RMBS and covered bonds. The spread difference exists here too – albeit with both markets trading considerably tighter – which I think shows that it’s the regulation that is really skewing these markets.

I’m not arguing that investing in the Spanish mortgage market is without risk. But I do believe that investors who, like us, don’t repo their bonds or need to hold capital against them can and should take advantage of these kinds of unintended regulatory consequences.

anthony_doyle_100

Europe’s debt/GDP levels are worse today than during the Euro crisis. So why are bond yields falling?

Two and a half years ago, there was a real fear in the marketplace that the euro would not survive. It appeared unlikely that Greece would be able to remain in the Eurozone and that some of the larger distressed economies like Italy and Spain may follow them out. High levels of government debt, unemployment and a banking system creaking under all this pressure did not bode well for the future. The mere possibility of a Eurozone nation leaving triggered massive volatility in asset markets from government bonds to equities, as investors grappled with the consequences of such an event occurring.

Of course, the bearish forecast for Europe did not eventuate. Perceptions had shifted significantly from the darkest days of the euro crisis. Politicians and central bankers have shown significant determination in keeping the euro intact, despite often only acting at the darkest hour. In markets, confidence returned after ECB President Mario Draghi’s now famous “whatever it takes” comment and it had a real effect on government bond yields with spreads over German bunds collapsing across the Eurozone.

Unfortunately for European government bond investors, the Eurozone could re-emerge as a source of risk. The reason is, since 2011 European government and economic fundamentals have generally gotten worse and not better.

2014-02 blog

When we look at the above table – which measure fundamental indicators like total investment, the unemployment rate and gross levels of government debt to GDP from 2011 and compares it to now – we can see a lot more red (which indicates a deterioration) than green (which indicates an improvement). Yet what is striking is that apart from Germany and the Netherlands who have seen their 10 year government bond yields increase slightly, all other European nations have seen their yields fall. This is not what we would expect to see given that various metrics like GDP, the unemployment rate, output gap and government debt to GDP are actually worse now than they were at the height of the Eurozone crisis.

I can see three main reasons why yields have fallen across the Eurozone despite a worsening in the economic statistics. The first is that confidence has returned and the credit risk premium demanded by bond investors has fallen. Investors in European bonds now believe that default risk has fallen from the dark days of 2011, despite a general worsening in conditions which would imply higher – and not lower – default risk. When Draghi said the ECB would do “whatever it takes”, the market believed him.

Secondly, the inflation risk premium that investors demand has collapsed as Eurozone inflation has collapsed. Low inflation in the Eurozone is largely the result of painful internal devaluation, high unemployment and government austerity. Countries like Ireland, Portugal and Greece are feeling this the most, having experienced deflation over the last couple of years. As we can see in the table, austerity has meant that budget deficits have improved across the Eurozone, but this has also resulted in deflationary forces becoming more pronounced. Lower European inflation means higher real yields, and this has contributed to nominal yields falling or remaining low in Eurozone government bonds. However, the danger for the periphery is that lower inflation implies lower nominal growth rates, and this means even greater pressure on the Eurozone periphery’s huge debt burdens. Markets should react to lower nominal growth rates by questioning these counties’ solvency, pushing bond yields higher.

Thirdly, the other main reason that peripheral yields have converged is that there are genuine signs of rebalancing, as indicated by improving current account balances and falling unit labour costs. The majority of Eurozone nations are now running a current account surplus, including Spain, Portugal, and Ireland. Despite being locked into the single exchange rate which is arguably way too high for these countries, global competitiveness has improved and exports have increased.

There are good reasons the euro will survive. However, it is important to question whether the market is charging a high enough credit risk premium given the challenges that continue to face the Eurozone. Increasingly, bond investors need to assess the risks of deflation in Europe as well. Arguably a lot of good news is priced in to government bond markets at the moment, and we remain hesitant to lend to those European countries displaying weaker financial metrics at this point in the cycle. With the IMF recently finding “no evidence of any particular debt threshold above which medium-term growth prospects are dramatically compromised”, it suggests that there are many more important things to bond investors than the public debt/GDP ratio (like credit growth, labour markets and inflation). Public debt/GDP ratios are what investors have been fixated on since the financial crisis, but they are a lazy and incomplete way of assessing the risks in government bond markets.

ben_lord_100

The M&G YouGov Inflation Expectations Survey – Q3 2013

Despite high unemployment rates, excess capacity and a sanguine inflation outlook from the major central banks, it is important to keep an eye on any potential inflation surprises that may be coming down the line. For instance, we only need to look at ultra easy monetary policy; low interest rates and improving economic growth to see that the risk of an unwelcome inflation shock is higher than perhaps at any time over the past five years. The development of forward guidance measures is a clear sign that central banking has evolved substantially from 2008 in the form of Central Bank Regime Change. It appears that there is a growing consensus that inflation targeting is not the magical goal of monetary policy that many had once believed it to be and that full employment and financial stability are equally as important.  Given that monetary policy appears firmly focused on securing growth in the real economy – at perhaps the expense of inflation targets – we thought that it would be useful to gauge the short and long-term inflation expectations of consumers across the UK, Europe and Asia. The findings from our August survey, which polled over 8,000 consumers internationally, is available in our latest report here.

The results suggest consumers continue to lack confidence that inflation will decline below current levels in either the short or medium term. Despite evidence that short-term inflation expectations may be moderating in some countries, most respondents expect inflation to be higher in five years than in one year. Confidence that the European Central Bank will achieve its inflation target over the medium term remains weak, while confidence in the Bank of England has risen.

The survey found that consumers in most countries continue to expect inflation to be elevated in both one and five years’ time. In the UK, inflation is expected to be above the Bank of England’s CPI target of 2.0% on a one- and five-year ahead basis. All EMU countries surveyed expect inflation to be equal to or higher than the European Central Bank’s HICP target of 2.0% on a one- and five-year ahead basis. Long-term expectations for inflation have changed little in the three months since the last survey, with the majority of regions expecting inflation to be higher than current levels in five years. Five countries expect inflation to be 3.0% or higher in one year: Austria, Hong Kong, Italy, Singapore and the UK.

Consumers in Austria, Germany and the UK have reported an increase in one year inflation expectations compared with those of the last survey three months ago. This is of particular relevance for the UK, where the Bank of England has stated three scenarios under which the Bank would re-assess its policy of forward guidance. The first of these “knockouts” refers to a scenario where CPI inflation is, in the Bank’s view, likely to be 2.5% or higher over an 18-month to two-year horizon. Short-term inflation expectations in Singapore and Spain continued their downward trend in the latest survey results, registering their third straight quarter of lower expectations.

Inflation expectations - 12 months ahead

Over a five-year horizon, the inflation expectations of consumers in Austria, Germany, Italy, Spain and Switzerland have risen. Whilst inflation expectations in Switzerland remain at the lowest level in our survey at 2.8%, consumers have raised their expectations from 2.5% in February. Long-term inflation expectations in France and the UK remained stable at 3.0%. Meanwhile, consumers in Hong Kong and Singapore have the highest expectations, at 5.0%, although the Hong Kong number shows a decline from 5.8% three months ago.

Inflation expectations - 12 months ahead

stefan_isaacs_100

It’s a new dawn, it’s a new day. The ECB takes baby steps towards QE

Just when you thought the Fed had well and truly killed the carry trade, a surprisingly dovish Mario Draghi reminded markets yesterday that Europe remains a very different place from the US. Having previously argued that the ECB never pre commits to forward guidance, yesterday marks something of a volte-face. ‘The Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time.’ The willingness to offer guidance brings the ECB closer to its UK and US peers, the latter having been in the guidance camp for some time. This firmly reinforces our view that the ECB retains an accommodative stance and an easing bias.

The willingness to offer forward guidance to the market no doubt came after some long and hard introspection within the Governing Council. So why the change ? Firstly, the ECB is worried that it may miss its primary target of maintaining inflation at or close to 2% over the medium term. Secondly, Draghi indicated an increasing concern that the real economy continues to demonstrate ‘broad based’ weakness, and finally, as has been the case for some time, the Council worries that the Eurozone continues to labour with subdued monetary dynamics. This sounds increasingly like Fed talk of recent years.

Draghi also expressed his concern yesterday during his Q&A at the effective tightening of monetary conditions via higher government bond yields (see chart) since the Fed’s tapering discussions. Frankly the last thing the Eurozone needs at this stage in its nascent recovery is higher borrowing costs.

Bond yield have risen

Draghi in communicating that the next likely move will be an easing of policy has attempted to talk bond yields down. European risk assets appear to have taken his comments positively but the bond market remains sceptical. At the time of writing only short to medium dated bonds are trading at lower yields.

In conjunction with revising down its 2013 Italian GDP forecast from -1.5% to -1.8%, the IMF has publicly urged the ECB to embark upon direct asset purchases. Is this a likely near term response ? For now those calls will likely fall on deaf ears especially with German elections later this year. The ECB clearly believes that its next move would be to cut rates further in response to a weaker outlook. Buying time seems to be the current approach.

However, should Eurozone inflation expectations continue to undershoot (the market is currently pricing 1.36% and 1.66% over the next 5 & 10 years, see chart)  and economic performance remain downright lacklustre across Europe, then the ECB will have to think very carefully about what impact it can expect from a ‘traditional’ monetary response. QE may be some way off, and would no doubt see massive objections from Berlin, but in the same way that the ECB never pre commits, maybe just maybe, QE will be on the table sooner than the market is currently anticipating.

Inflation expectations in Europe

jim_leaviss_100

Do Central Banks tell us too much for our own good?

I read in The Times last week that the Shadow Monetary Policy Committee (a panel of economists and Bank of England alumni) thinks that the Bank of England should announce a freeze on UK rates for an extended period of time. The Federal Reserve also had this policy (now replaced by even more explicit guidance about the unemployment rate and inflation levels), as did the Bank of Canada. In the past few years the Fed has spent weeks debating its communications strategy. Elsewhere we get monthly press conferences (including in Trichet’s time as head of the ECB the use of the explicit codewords “strong vigilance” which meant “rates going up next month”). We also get Inflation Reports and Financial Stability Reports, fan charts and GDP forecasts from which market economists pronounce that the Bank’s two year ahead projection means no more QE just yet. I wonder though whether we’re being given too much information, and that in telling us exactly what they are going to do, central banks risk either a) having to not change their policy even if economic circumstances mean that they should (for example if economic growth comes back strongly yet they’ve promised to keep rates on hold for years), or b) lose face, credibility and trust with the market by going back on their promise. Each of these actions has a cost, and should lower an economy’s potential GDP rate.

Is the promise of low rates forever fuelling the return of those Four Horsemen of the Bondocalypse – CLOs, PIK notes, CCC rated high yield issuance, and mega – LBOs? Does it lead to complacency in investment? To schemes that can only survive if rates don’t ever rise? Is current central bank policy generating asset bubbles? And what are central bankers left with, without the ability to surprise and shock? Worse still, what if “low rates forever” has the opposite effect than intended? Does it say “doomed, we’re all doomed”? Perhaps central bankers should realise that keeping us guessing is their most powerful tool (OK maybe QE Infinity is their most powerful tool, but still).

The clip below is of Diego Maradona, scoring against England in the Mexico World Cup finals in 1986.

I was reminded of it when I picked up a copy of Steve Hodge’s autobiography The Man With Maradona’s Shirt in the sales. Maradona was fortunate enough to swap shirts with Nottingham Forest legend Hodge after that game. Anyway, back in 2005 Bank of England Governor gave a speech in which he said the most interesting thing a central banker ever said.

“The great Argentine footballer, Diego Maradona, is not usually associated with the theory of monetary policy. But his performance against England in the World Cup in Mexico City in June 1986 when he scored twice is a perfect illustration of my point. Maradona’s first “hand of God” goal was an exercise of the old “mystery and mystique” approach to central banking. His action was unexpected, time-inconsistent and against the rules. He was lucky to get away with it. His second goal, however, was an example of the power of expectations in the modern theory of interest rates. Maradona ran 60 yards from inside his own half beating five players before placing the ball in the English goal. The truly remarkable thing, however, is that, Maradona ran virtually in a straight line. How can you beat five players by running in a straight line? The answer is that the English defenders reacted to what they expected Maradona to do. Because they expected Maradona to move either left or right, he was able to go straight on. ”

If Maradona had put out a press release and a booklet explaining exactly what he was going to do, it could never have happened. But by keeping the England team guessing and by shifting his weight from left to right (the footballing equivalent of raised eyebrows) he scored the greatest goal of all time.

anthony_doyle_100

Another year over – 2012 returns in fixed income markets

It’s been another massive year for the global economy. Europe saw LTROs, Greece got a haircut, sovereign downgrades and record high unemployment rates. The peripheral European nations attempted to implement austerity measures with limited success. The US re-elected President Obama and the focus quickly shifted to the upcoming fiscal cliff. In the UK, an Olympics induced bounce in growth was the sole bright spark for an economy which appears to be stuck in quick sand and may well lose its prized AAA rating in 2013.

The IMF, being unusually succinct, probably summed up the state of the global economy the best by entitling their latest World Economic Outlook “Coping with High Debt and Sluggish Growth”. The advanced economies account for around two-thirds of global GDP and if they are sluggish then global growth will be sluggish too.

With all this uncertainty and risk in 2012, how have fixed income markets performed? Surely government bonds will be the safe haven of choice?

In absolute and local currency terms, it’s been another great year for the markets with everything generating a positive return except UK linkers. It’s been a fall in grace for UK linkers, which were actually one of the best returning asset classes of 2011. The UK linker market was buffeted in 2012 by weak growth expectations and uncertainty surrounding proposed changes to the RPI calculation.

But looking elsewhere, investors had the opportunity to secure some excellent returns in 2012 by taking some risk. The best performing asset class of our sample was European subordinated financial debt which registered a return of 29.5%. European high yield wasn’t far behind with a return of 27.1%, followed by Sterling banks which returned 23.0%.

ECB President Mario Draghi and the ECB’s measures to support the Eurozone also had a positive effect of debt investors in peripheral Eurozone debt, with an index made up of bonds from Greece, Ireland, Italy, Portugal and Spain government bonds up 18.7%. Not a bad return for investors considering the question marks hanging over the ability of these nations to service their respective debt obligations in an environment of political uncertainty and recessionary levels of growth.

Other highlights include global high yield (up 18.7%), European peripheral financials (up 17.0%) and US high yield (up 15.6%). At the less risky end of the spectrum, European investment grade corporates returned 12.8% and US investment grade corporates returned 10.2%. Emerging market debt also did well, with EM sovereigns debt posting a fantastic return of 21.4%.

The dash for trash – YTD total returns in fixed income

As outlined earlier, it appears that the global economy faces some substantial fundamental headwinds. So how was it that the riskiest asset classes in fixed income have performed the best? Three little words – “whatever it takes”. Mario Draghi’s speech in late July supercharged returns for the riskiest asset classes and stimulated the “dash for trash”. “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”.

Well Mr Draghi, the markets have certainly believed you. For example, an index of government debt issued by Greece, Ireland, Italy, Spain and Portugal had up until the speech date generated a return of around 5%. The index ended up generating a 17% return, with investors comforted by Mr Draghi’s comments.

Super Mario to the rescue

It seems to us that the Ostrich effect (the avoidance of apparently risky financial situations by pretending they do not exist) had a significant impact on markets in 2012. And in a world of ultra-low interest rates and negative real returns in cash, investors must take on risk. It is precisely what central banks are encouraging us to do. But uncertainty breeds volatility and in order to generate higher returns investors must face this volatility head on. It will be a feature of the market in 2013.

About the only thing we can say for certain is that it is unlikely that fixed income will continue to generate excellent returns across the spectrum from government bonds to high yield. For example, double-digit returns in European investment grade are not normal and has occurred only three times in the last seventeen years. On the other hand, the asset class has posted a negative return in only two of those seventeen years, with the largest loss being -3.3% in 2008. In US high yield, the consensus amongst analysts is that high yield markets will generate a return of around 4-6%, the result of coupon clipping. Analysing returns for the asset class shows that a coupon-clipping year has occurred only once in the past twenty-five years.

We posted our bond market outlook last week. It looks like the US may experience a housing induced growth spurt, Europe will eventually get round to dealing with its issues and the UK has a long way to go to secure economic growth. We like non-financial corporates, are worried about EM debt valuations and remain confident that there are still attractive investment opportunities in several areas of the fixed income universe. For an expansion of these views and more, please see here.

anthony_doyle_100

Jim’s outlook for 2013. Eurozone volatility, poor emerging market debt valuations and a sterling collapse. Merry Christmas!

It may not have felt like it, but 2012 has actually been a pretty good year for investors. Bond holders in particular have had a decent 12 months: the government bond bull run has continued and investment grade and high yield corporate debt appears on track to deliver some excellent returns. Major equity markets also look likely to end the year in the black.

These broad-based gains on global stock and bond markets have occurred against a still challenging macroeconomic backdrop. In fact, looking back at our last annual outlook, many of the things we were worried about then – “double dips” and rising indebtedness in developed countries and the risk of a significant policy error worldwide – have not only remained unresolved but have become, in some cases, more of a concern. But it’s not all bad news and we’re pleased to note pockets of progress in some parts of the world.

So what does 2013 have in store for financial markets? In our latest Panoramic outlook, Jim outlines his macroeconomic and market forecasts for the year ahead. And remember, there are still a couple of days left to enter the M&G Bond Vigilantes Christmas quiz for 2012.

Enjoy!

jim_leaviss_100

Central Bank Regime Change: an update following the Fed last night, and Carney the day before

Last night’s move by the Federal Reserve to change its approach to US monetary policy to effectively reduce the focus on the inflation target was just the latest step in an accelerating project by the world’s monetary authorities.   In a world where unemployment rates are well above pretty much anyone’s estimate of the natural rate, and in many geographies well above 10%, the need for growth is seen as much more pressing that the fear of missing the 2% inflation targets.  So at the latest FOMC meeting the Fed decided that inflation would be tolerated if it nudged higher to 2.5% as long as unemployment remained too high (above 6.5%).  You can read the text of the Fed’s statement here.

We call this move by the world’s authorities away from the old idea of 2% inflation targets Central Bank Regime Change.  We wrote this blog about it in March. The chart is worth showing again.

central bank regime change

The chart from the IMF shows us that in the period post Paul Volcker’s appointment to the US Fed in 1979 (the orange line), the monetary authorities kept interest rates higher than the rate of inflation (they were reacting to the damage that inflation caused in the 1970s).  As a result inflation steadily fell – and as well as high “real” rates, the rhetoric was all about inflation (inflation targets, the Bank of England’s Inflation Report, independent central banks).  It’s been an awesome 30 years (on the whole!) to be a government bond investor, as yields fell in response to inflation fighting credibility.  However, I’ve added another line to the IMF chart (blue), showing how central banks have behaved since Lehman went bust, and the credit crisis was followed by the sovereign debt crisis.  It’s a very different story, with sharply negative real yields.  Nominal interest rates are near zero in much of the developed world, yet inflation has been sticky above 2%.  This is deliberate central bank policy – negative real rates are designed to make it attractive to borrow to invest and stimulate growth (and to deliver gains to indebted consumers), and also to encourage risk taking as investors reach for yield (government bond investors buy credit, investment grade investors buy high yield etc.).

Negative real rates also have an impact which we’ll discuss in more detail another time – debt reduction for bust governments.  There are a few ways to reduce debt burdens:  strong real growth (seems out of reach for the foreseeable future), austerity (unproven and probably counter-productive, although some point to Canada and Sweden as success stories), default (will be necessary for some Eurozone economies without their own currency to depreciate) and inflation.  It’s the last that’s likely to be effective – and as the red line on that chart shows, it’s the method by which the western economies reduced the war debts following WWII.

So whilst we don’t believe the world’s central bankers and finance ministers are sitting high in some Swiss cable car complex, stroking white fluffy cats and cackling maniacally, plotting to generate super high levels of inflation, this is becoming the pragmatic (only?) response to a world without other policy responses (no fiscal flexibility left).  Now the Fed’s latest move to target both inflation AND unemployment rates is very interesting – when I was a young student of economics, the idea that you could chose BETWEEN inflation and unemployment was discredited.   To quote, er, Wikipedia on that idea, known as the Philips Curve “while it has been observed that there is a stable short run tradeoff between unemployment and inflation, this has not been observed in the long run”.  So the idea that you can choose both is probably even more far fetched.

Anyway, what does the Fed’s action mean?  Well watching Bernanke’s press conference last night it struck me that in changing the Fed’s guidance away from the “no hikes until 2015” towards the unemployment and inflation numerical targets should actually be seen as a potential monetary TIGHTENING.  After all, we are exceptionally bullish on US housing as a driver for growth in 2013 and 2014, so if things go well we could end up with the Fed raising rates ahead of the old 2015 date.

So I’ve asserted that Central Bank Regime change is taking place, but I thought it would be worthwhile to put together a brief list of the evidence so far.  Here it is.

Evidence for Central Bank Regime Change

  1. The level of real rates set by the Central Banks: the best evidence is obviously shown on the graph itself.  Are central bankers hitting inflation targets?  Not really – for example the Bank of England has only had CPI at or below the 2% target for 6 months in the last 5 years, and for much of that period it’s been above 3% (and above 5% at one point!).  On latest data the UK, the Eurozone and the US all have negative real rates of 1.75% or higher.  Western central banks are even considering setting negative NOMINAL interest rates.  Only Japan of the major economies has positive real rates at the moment – although we think this might change dramatically, as I’ll discuss below.
  2. The US refocus on the dual mandate: after three decades of inflation targeting, the Fed has been moving towards this new objective for a year or so now.  First Charles Evans of the Chicago Fed started floating the concept of an unemployment target, then Janet Yellan (Bernanke’s probable successor) of the San Francisco Fed joined him, leading up to last night’s actions.  This was pushing on an open door for Ben Bernanke who has written the following in his previous academic life…
  3. Bernanke’s 4% inflation target for Japan:  in this paper, Japanese Monetary Policy: A Case of Self-Induced Paralysis, written whilst he was at Princeton in 1999, Bernanke argues that the solution for an economy like Japan with a burst property bubble, broken banks, sluggish growth and deflationary pressures should be to target inflation of between 3% and 4%.  Looks similar to the US situation, so why wouldn’t Bernanke think that this is the correct response from the Fed for the US?
  4. Mervyn King’s softening stance on the inflation target:  I guess actions speak louder than words, and the lack of actual inflation targeting in the UK for the last 5 years should tell you more than any speech, but I’d never heard the Governor soften his rhetoric until these words in this speech Twenty Years of Inflation Targeting this October.  “There may be circumstances in which it is justified to aim off the inflation target for a while in order to moderate the risk of financial crises”.
  5. New Bank of England Governor Mark Carney talks about a new regime of nominal GDP targeting rather than pure inflation targets: in a speech to the CFA Society of Toronto this week, Carney (who takes over at the BoE next year) suggested that when policy rates approach 0% (the “zero bound”), targeting nominal growth might be more effective than targeting inflation rates.   He even used, for the first time from a central banker (?) the term “regime change”.  “Under Nominal GDP targeting, bygones are not bygones and the central bank is compelled to make up for past missed on the path of nominal GDP.”   Of course, targeting nominal GDP is a very effective way of reducing debt levels in an economy too.
  6. Japanese regime change, the “Abe Trade”: this weekend Japan goes to the polls with opposition leader Shinzo Abe of the LDP favourite to emerge as the new Prime Minister.  Japan has yet to recover from its bust, decades ago, and Abe wants to aggressively target growth.  With deflation of 0.4% in Japan despite the BoJ’s 1% inflation target, Abe wants the central bank to do MUCH more.  This would include raising the inflation target to 2% (or even 3%) and doing whatever it takes (more QE, currency intervention) to achieve that.  This is a manifesto commitment that might get watered down at a later date – but having seen a BoJ member in Tokyo recently I get the feeling that a hike in its inflation target is inevitable.
  7. Europe: hard evidence is more difficult to find, but with hawkish German ECB members like Axel Weber and Juergen Stark both resigning in 2011 (“It’s generally known that I’m not a glowing advocate of these (bond) purchases” – Stark) the ECB has been much more open to extraordinary balance sheet expansion (LTRO, SMP, OMT).  And to more “traditional” Quantitative Easing at a later date?

So with all of this evidence that the authorities are changing how they think, and act, on inflation, you would expect that bond markets would have reacted badly right? If Ben Bernanke thinks 4% is an appropriate level for inflation in the US, you wouldn’t be lending money to the government at 0.65% for the next 5 years would you? And with Mark Carney taking over at the BoE next year, breakeven inflation rates (i.e. market inflation expectations) would be overshooting the 2% inflation target over the next few years too? Well 5 year Treasury yields are still well below 1% (helped by QE buying of that sector, announced last night) and UK breakeven inflation rates on a CPI basis are below the 2% inflation target. In both cases it feels as if state intervention in these markets (financial repression through QE, capital requirements etc.) will keep yields low despite high inflation. And this is entirely necessary – with half the US Treasury market maturing in the next 3 years or so, if yields ever did adjust higher then western governments, with marginal solvency in any case, could go bust quickly.

Page 1 of 41234