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The M&G YouGov Inflation Expectations Survey – Q3 2014

The results of the August 2014 M&G YouGov Inflation Expectations Survey suggest that inflation expectations have moderated across the UK, most European countries and Asia. Short-term inflation expectations in the UK have fallen from 2.3% to 2.2% after an upwards bounce in the May survey. However, over a five year period, expectations remain unchanged at 3.0% for the 7th consecutive quarter. UK consumers have modestly raised their confidence in the Bank of England, with 49% of respondents now expecting Mark Carney to deliver on price stability.

In Europe, short-term inflation expectations remain unchanged at 2.0% in Spain, Italy and Germany. However, in France, the expected rate of inflation for the next 12 months has dropped a full percentage point over the quarter and is now just 1.0%, the lowest level in the history of the survey. Notably, a larger proportion (48%) of French respondents believe their net income will decrease over the next 12 months, despite the fall in inflation expectations.

M&G YouGov inflation expectations - 1 year ahead

Over the long term, inflation expectations in all Eurozone countries surveyed except France remain above the European Central Bank (ECB) target, although there are signs of moderation in some countries. Compared to last quarter, inflation expectations have fallen across Austria, France and Italy, although not in Germany and Spain, where they have held steady at 3.0%. The downward pressure is most evident in Italy and France where long-term expectations have fallen to 2.5% and 2.0% respectively, amid an increasingly challenging political environment. The number of Italians in disagreement with their government’s current economic policy has increased notably over the quarter from 44% to 53%. Switzerland stands out as being the only country to report a rise in short-term inflation expectations (from 1.1% to 1.3%) and also for the high level of confidence that Swiss consumers continue to place on their central bank (54%).

M&G YouGov inflation expectations - 5 years ahead

In Asia, the gauge for inflation over the short term has fallen to the lowest level since the inception of the survey (Singapore 3.4% and Hong Kong 4.0%). Interestingly, despite reporting a reasonably high level (45%) of confidence in their central bank’s ability to achieve its inflation target, consumers in Singapore nevertheless expect inflation to more than triple to 4.6% over the next five years.

The findings and data from our Q3 survey, which polled almost 8,500 consumers internationally, is available in our latest report here or via @inflationsurvey on Twitter.

M&G YouGov Inflation Expectations Survey 

 

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Exceptional measures: Eurozone yields to stay low for quite some time

Richard recently wrote about the exceptional times in bond markets. Despite bond yields at multi-century lows and central banks across the developed world undertaking massive balance sheet expansions the global recovery remains uneven.

Whilst the macro data in the US and UK continues to point to a decent if unspectacular recovery, the same cannot be said for the Eurozone. Indeed finding data to be overly optimistic about is no easy task. Both consumer and business confidence indicators continue to point to a subdued recovery; parts of Europe are technically back in recession and inflation readings continues to disappoint to the downside. The most recent CPI reading came in at a mere 0.4%, German breakevens currently price five year inflation at 0.6% and longer term expectations have shown signs of questioning the ECB’s ability to deliver on the inflation mandate.

Recognising the sheer size of the Eurozone banking system remains key to understanding the challenge Eurozone policymakers face. With a banking system over three times larger than the US (relative to GDP); significantly higher non-performing loans and massive pressure to deleverage as shown in the first chart below, it is unsurprising that the so called transmission mechanism appears damaged. The failure to pump credit into the Eurozone economy, especially into the periphery, continues to weigh on funding costs for SMEs & promote exceptionally high levels of unemployment. These are only now beginning to stabilise at elevated levels as shown in the second chart below.

Banks have started the deleveraging process

Peripheral Europe

With previous demands for austerity in Europe preventing economies from running counter-cyclical fiscal policies and uneven progress in structural reform, the onus continues to fall on monetary policy and the ECB. And yet for a variety of reasons the response has fallen considerably short of that from the FED, BoE & BoJ, who have been happy to expand their balance sheets considerably.

Balance Sheets

The result has been, an overvalued Euro, imported disinflation and a lack of investment. Having offered re-financing cuts, forward guidance, massive liquidity in the form of the LTRO & TLTRO, the ECB will ultimately be forced to follow other central banks in undertaking broad asset purchases.

Whilst these broad asset purchases or QE are unlikely to be unveiled today, they are the only likely means in the near term, of ensuring that the banking system in Europe is able to extend significantly more credit to the real economy. This in turn should help to raise inflation expectations, boost potential growth and allow the ECB to fulfil its mandate.

In Europe exceptional times call for exceptional measures. The ECB isn’t done, even if certain members will have to be dragged kicking and screaming to the QE party. I expect European bond yields to stay low for quite some time.

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Why aren’t bund yields negative again?

Whether or not you believe that the ECB moves to full government bond purchase quantitative easing this week (and the market overwhelmingly says that it’s only a remote possibility) the fact that German bund yields at the 2 year maturity remain positive is a bit surprising. The 2 year bund currently yields 0.05%, lower than the 0.2% it started the year at, but higher than you might have expected given that a) they have traded at negative yields in 2012 and 2013 and b) that the market’s most likely expected outcome for Thursday’s meeting is for a cut in the ECB’s deposit rate to a negative level.

The chart below shows that in the second half of 2012, and again in the middle of 2013, the 2 year bund yield was negative (i.e. you would expect a negative nominal total return if you bought the bond at the prevailing market price and held it to maturity), hitting a low of -0.1% in July 2012.

2y bund yields chart

Obviously in 2012 in particular, the threat of a Eurozone breakup was at its height. Peripheral bond spreads had hit their widest levels (5 year Spanish CDS traded at over 600 bps in July 2012), and Target2 balances showed that in August 2012 German banks had taken Euro 750 billion of “safe haven” deposits from the rest of the euro area countries (mostly from Spain and Italy). So although the ECB refinancing rate was at 0.75% in July 2012 compared with 0.25% today, the demand for German government assets rather than peripheral government assets drove the prices of short dated bunds to levels which produced negative yields.

This time though, whilst the threat of a euro area breakup is much lower – Spanish CDS now trades at 80 bps versus the 600 bps in 2012 – the prospect of negative deposit rates from the ECB might produce different dynamics which might have implications for short dated government bonds. The market expects that the ECB will set a negative deposit rate, charging banks 0.1% to deposit money with it. Denmark successfully tried this in 2012 in an attempt to discourage speculators as money flowed into Denmark out of the euro area. Whilst the ECB refinancing rate is likely to remain positive, the cut in deposit rates might have significant implications for money market funds. David Owen of Jefferies says that there is Euro 843 billion sitting in money market funds in the euro area, equivalent to 8.5% of GDP. But what happens to this money if rates turn negative? In 2012, when the ECB cut its deposit rate to zero, several money market fund managers closed or restricted access to their money market funds (including JPM, BlackRock, Goldman Sachs – see FT article here). Many money market funds around the world guarantee, or at least imply, a constant or positive net asset value (NAV) – this is obviously not possible in a negative rate environment, so funds close, at least to new money. And if you are an investor why would you put cash into a money market fund, taking credit risk from the assets held by the vehicle, when you could own a “risk free” bund with a positive yield?

So whilst full blown QE may well be months off, if it ever happens, and whilst Draghi’s “whatever it takes” statement means that euro area breakup risk is normalising credit risk and banking system imbalances, the huge amount of money held in money market funds that either wants to find positive yields, or is forced to find positive yields by fund closures, makes it a puzzle as to why the 2 year bund yield is still above zero.

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Is Europe (still) turning Japanese? A lesson from the 90’s

Seven years since the start of the financial crisis and it’s ever harder to dismiss the notion that Europe is turning Japanese.

Now this is far from a new comparison, and the suggestions made by many since 2008 that the developed world was on course to repeat Japan’s experience now appear wide of the mark (we’ve discussed our own view of the topic previously here and here). The substantial pick-up in growth in many developed economies, notably the US and UK, instead indicates that many are escaping their liquidity traps and finding their own paths, rather than blindly following Japan’s road to oblivion. Super-expansionary policy measures, it can be argued, have largely been successful.

Not so, though, in Europe, where Japan’s lesson doesn’t yet seem to have been taken on board. And here, the bond market is certainly taking the notion seriously. 10 year bund yields have collapsed from just shy of 2% at the turn of the year and the inflation market is pricing in a mere 1.4% inflation for the next 10 years; significantly below the ECB’s quantitative definition of price stability.

So just how reasonable is the comparison with Japan and what could fixed income investors expect if history repeats itself?

The prelude to the recent European experience wasn’t all that different to that of Japan in the late 1980s. Overly loose financial conditions resulted in a property boom, elevated stock markets and the usual fall from grace that typically follows. As is the case today in Europe, Japan was left with an over-sized and weakened banking system, and an over-indebted and aging population. Both Japan and Europe were either unable or unwilling to run countercyclical policies and found that the monetary transmission mechanism became impaired. Both also laboured under periods of strong currency appreciation – though the Japanese experience was the more extreme – and the constant reality of household and banking sector deleveraging. The failure to deal swiftly and decisively with its banking sector woes – unlike the example of the US – continues to limit lending to the wider Eurozone economy, much as was the case in Japan during the 1990s and beyond. And despite the fact that Japanese demographics may look much worse than Europe’s do today, back in the 1990s they were far more comparable to those in Europe currently.

Probably the most glaring difference in the two experiences is centred around the labour market response. Whereas Eurozone unemployment has risen substantially post crisis, the Japanese experience involved greater downward pressure on wages with relatively fewer job losses and a more significant downward impact on prices.

With such obvious similarities between the two positions, and whilst acknowledging some notable differences, it’s surely worthwhile looking at the Japanese bond market response.

As you would expect from an economy mired in deflation, Japan’s experience over two decades has been characterised by extremely low bond yields (chart 1). Low government bond yields likely encouraged investors to chase yield and invest in corporate bonds, pushing spreads down (chart 2) and creating a virtuous circle that ensured low default rates and low bond yields – a situation that remains true some 23 years later.

Japan and Germany 10 year government bond yields

Japan and Germany corporate bond yields

As an aside, Japanese default rates have remained exceptionally low, despite the country’s two decades of stagnation. Low interest rates, high levels of liquidity, and the refusal to allow any issuers to default or restructure created a country overrun by zombie banks and companies. This has resulted in lower productivity and so lower long-term growth potential – far from ideal, but not a bad thing in the short-to-medium term for a corporate bond investor. With this in mind, European credit spreads approaching historically tight levels, as seen today, can be easily justified.

Can European defaults stay as low as for the past 30 years

Europe currently finds itself in a similar position to that of Japan several years into its crisis. Outright deflation may seem some way off, although the risk of inflation expectations becoming unanchored clearly exists and has been much alluded to of late. Japan’s biggest mistake was likely the relative lack of action on the part of the BOJ. It will be interesting to see what, if any response, the ECB sees as appropriate on June 5th and in subsequent months.

BoJ basic discount and ECB main refinancing rates

Though it is probably too early to call for the ‘Japanification’ of Europe, a long-term policy of ECB supported liquidity, low bond yields and tight spreads doesn’t seem too farfetched. The ECB have said they are ready to act. They should be. The warning signs are there for all to see.

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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.

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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.

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Technical support for Euro IG; around 4% of the market set to mature this month

Benjamin Franklin said that death and taxes were the only inevitabilities in life. I’d like to add the discussion of the January effect to his list. Every year I receive at least one piece of commentary telling me that January is always a good month for risk assets (we’re far from innocent ourselves – see here).

Basing investment decisions purely on seasonal anomalies isn’t a particularly reliable investment process and the sensible investor should take other, more robust information into account when making changes to their portfolio.

The improving economic outlook for Europe and the general lack of pessimism should help the European credit market rally this month. So too should the fact that about €64bn worth of investment grade bonds are set to have matured by the end of the month. I think it rather unlikely that we’ll see enough supply to offset the bonds that are maturing. J.P. Morgan recently publishing a research piece pointing out that gross European investment grade issuance has only ever been higher than €64bn a month on four occasions in the past, and all were prior to 2008.

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J.P. Morgan also point out that January has been on average the month when most issuance takes place throughout the year. The primary market has been true to form since 2014 began but it will need to maintain the pace of the roughly €16bn that was issued in the first week of the year to give investors with maturing bonds somewhere to put their cash.

If net issuance turns out to be negative in January it will be a key technical support that could see Euro investment grade spreads continue to tighten further. It will also give us all another nice data point to talk about come next January.

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Winners of our @inflationsurvey competition. The M&G YouGov Inflation Expectations Survey for 4Q 2013 will be released next week.

Beginning of November, we published a blog announcing the release of our Q4 YouGov Inflation Expectations Survey for early December. We are now in the final stages of collating and analysing the survey results and will publish the full report in the coming days on Twitter (@inflationsurvey) and our bond vigilantes blog. For those of you who are not aware (where have you been?!), the survey was created by M&G’s retail fixed interest team in partnership with YouGov. We ask over 8,000 consumers from the UK, Europe, Hong Kong and Singapore what their expectations are for inflation over the next 1 and 5 years. This has grown ever more important as central banks have sought to manage interest rate expectations through forward guidance.

The results of the Q3 Survey published last September as well as previous surveys are available here.

So congratulations to the 15 winners listed below, who were chosen at random amongst all our @inflationsurvey followers and who will each receive a copy of Frederick Taylor’s “The Downfall of Money”. We will DM each of you asking for your address so we can send you the book.

Simon Lander @simonlander01
Britmouse  @britmouse
Ian Burrows  @ian_burrows
Richard Lander  @richardlander
Iain Martin ‏  @_IainMartin
Morningstar UK ‏  @mstarholly
Brian Simpson ‏  @simpsob1
Amir Rizwan  @amirriz1
Tim Sharp ‏  @tm_sharp
Leanne Hallworth ‏  @leanneha41
Kevin Fenwick @kevinfenwick
Nico  @nicolocappe
qori nasrul ulum  @reme_dial
Alexander Latter  @AlexanderLatter
Ace AdamsAllStar  @AceAdamsAllStar

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Competition: follow @inflationsurvey on Twitter to have a chance to win one of 15 copies of The Downfall of Money by Frederick Taylor

At the end of October, the Citigroup Inflation Expectations survey showed a record jump in UK inflation expectations. The medium term expectation for UK inflation rose from 3.3% in September to 3.9%, and the number of people expecting inflation over 5% also rose significantly. Inflation expectations have become increasingly important in the UK because, as part of Bank Governor Carney’s new forward guidance regime announced in August, the Bank can raise rates even if unemployment remains high if inflation expectations become “unanchored”. Of course the period when the Citigroup survey was conducted was one where the major UK energy suppliers had announced annual price hikes of around 10%, and this spike in inflation expectations may well not persist. But it will have worried the Bank, and the gilt market fell on the release of the data.

Whilst UK inflation was making the news for its potential to surprise on the upside, Europe faced a very different scenario. October’s euro area CPI reading came in at an annual rate of 0.7%, down from 1.1% in September and below the market’s expectations. A Taylor Rule would suggest that with inflation so far from the ECB’s target of 2%, the central bank should be aggressively easing monetary policy (beyond today’s 25 bps cut, and beyond the zero bound to include QE?).

The next M&G YouGov Inflation Expectations Survey for the UK, European and Asian economies will be released in December. These M&G YouGov surveys are based on the best practice methodology discussed by the New York Fed (for example asking people about inflation rather than “prices of things you buy” as that sort of question tends to make people think solely of milk, bread and beer). We also have a bigger data sample than many of the other inflation surveys. Finally we also ask some interesting supplementary questions on issues like government economic policy credibility. As inflation expectations become increasingly important to central banks we think that we need to pay more attention to them – to date they have been well anchored, despite money printing through QE, but if this changes then so will central bank behaviour.

The Q4 M&G YouGov Inflation Expectations Survey will be released through Twitter. Follow @inflationsurvey to get the release time and date, and also to access the detailed report in December. The feed will also tweet on other inflation surveys and measures of inflation expectations. We hope you find it useful.

To encourage you to follow @inflationsurvey and be first to get the survey results, everybody who does so (and existing followers) will be put into a draw to win one of 15 copies of Frederick Taylor’s The Downfall of Money. This is the story of Germany’s hyperinflation of the 1920s, where the Reichmark fell to 2.5 trillion to the US dollar, and the economy collapsed – arguably sowing the seeds of the Second World War.

9781620402368

Click here for terms and conditions.

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The European monetary zone getting back on course ?

In my last blog I focused on the transition mechanism of financial policy in the UK, with government actions targeting the housing market, thus having the effect of loosening monetary policy. This encouraged us to look once again at the situation in Europe. Is the ECB any nearer making the monetary transmission system actually work?

Back in May 2011 we wrote about how the monetary system in the eurozone was not working effectively because different nations faced different interest rates in the private and public sector. One central bank rate was not being transmitted across the whole eurozone.

By using official money market rates as depicted by Euribor and adding bank CDS spreads as a proxy for the real cost of borrowing, we illustrated the difficulty the ECB was having in transmitting a single policy through a fractured financial system. We have brought the chart up to date below, and as you can see, the situation is no longer as extreme.

Estimate of marginal funding cost for peripheral banks

Thankfully, some semblance of order is being returned. The drag on growth from the massive fiscal adjustment that most of Europe has been through over the past few years could be petering out. Hopefully, less restrictive policy will point to future economic growth across the region. Although some progress has been made and funding costs have come down, access to credit remains restricted for many in the real world (see for example Ana’s blog from August). But if the ECB and the authorities can continue to heal the banking system then a virtuous circle of confidence could return to the eurozone, once again making loose monetary policy set by the ECB flow into the real world in the periphery.

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