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How do house prices feed into inflation rates around the world? It’s important for central banks, and for bond investors.

After the collapse in real estate prices in many of the major developed nations during and after the Great Financial Crisis, housing is back in demand again. Strong house price appreciation is being seen in most areas of the US, in the UK (especially in London), and German property prices have started to move up. We’re even seeing prices rise in parts of Ireland, the poster child for the property boom and bust cycle. I wanted to take a quick look at what rising house prices do for inflation rates. Not the second round effects of higher house prices feeding into wage demands, or the increased cost of plumbers and carpets, but the direct way that either house prices, mortgage costs and rents end up in our published inflation stats. Also, the question about whether central banks should target asset prices is another debate too (there’s some good discussion on that here).


There is no simple answer to the question “how do house prices feed into the inflation statistics”. It varies not just from country to country, but also within the different measures of inflation within one geographical area. But given central banks’ rate setting/QE behaviour is determined by the published inflation measures it’s important to understand how house prices might, or might not, drive changes in those measures.

The US

“Shelter” is around 31% of the CPI which is used to determine the pricing of US inflation linked bonds (TIPS), but just 16% of the Core PCE Deflator, the measure that the Federal Reserve targets. The PCE is a broader measure, with much bigger weights to financial services and healthcare, so shelter measures therefore have to have a smaller weight in that measure. The CPI shelter weight looks high by international standards. For the Bureau of Labor Statistics, the purchase price of a house is not important except in how it influences the ongoing cost of providing shelter to its inhabitants. The method that the BLS uses to determine what those costs might be is “rental equivalence”. It surveys actual market rents, and augments this data by asking a sample of homeowners to estimate what it would cost them to rent the property that they live in (excluding utility bills and furniture). You can read a detailed explanation of this process here. In both the CPI and PCE, pure market rents are given around a quarter of the weight given to OER, Owners’ Equivalent Rent. There are problems with this – and not just with the accuracy of the homeowners’ rental guesses. Having rents and rental equivalence in the inflation data rather than a house price measure means that you can have – simultaneously – a house price bubble, and a falling impact from house prices in the inflation data. We’ve seen times when a speculative frenzy means house prices rise, but the impact of that speculation is overbuilding of property (just before the 2008 crash there was 12 months of excess inventory of houses in the US compared to a pre-bubble level of around 5 months) leading to falling rents. The reverse happened as the US recovered. House prices continued to tank, but because of a lack of mortgage finance more people were forced to rent, pushing up rents within the inflation data.

The UK

How house prices feed into the UK inflation data depends on whether you care about CPI inflation (which the Bank of England targets) or RPI inflation (which we bond investors care about as it’s the statistic referenced by the UK index linked bond markets). House prices directly feed into the RPI, but because house prices have little direct input into the CPI, the recent trend higher in UK property will lead to a growing wedge between the two measures – good news for index linked bond investors! The RPI captures house price rises in two ways – through Mortgage Interest Payments (MIPs) and House Depreciation. Mortgage payments will increase as the price of property rises, but they will most quickly reflect changes in interest rates. For example Alan Clarke of Scotia estimates that a hike in Bank Rate of 150 bps would feed almost immediately into the RPI, adding 1% to the annual rate. This is despite the trend in the UK for people to fix their mortgage payments. Housing Depreciation linked to UK house prices with a lag, and is an attempt to measure the cost of ownership (a bit like the BLS’s aim with rental equivalence) but has been criticized as overstating the cost of ownership in rising markets as house price inflation is almost always about land values accelerating rather than the bricks and mortar themselves. Land does not depreciate like other fixed assets (no wear and tear). Housing is very significant in the UK RPI, making up 17.3% of the basket (8.6% actual rents, 2.9% MIPs, 5.8% depreciation).

The UK’s CPI is a European harmonised measure of inflation. It only takes account of housing costs through a 6% weight on actual rents. There has never been agreement within the EU about how wider housing costs should be measured! Countries with high levels of home ownership have different views from countries with a high proportion of renters. Housing is around 18% of the expenditure of a typical person in the UK, so the Office of National Statistics regards the current CPI weight as a “weakness”. They therefore are now publishing CPIH, which includes housing on a rental equivalence basis (the same idea that the ONS measures “the price owner occupiers would need to rent their own home” as a dwelling is a “capital good, and therefore not consumed, but instead provides a flow of services that are consumed each period”). CPIH has a 17.7% weight to housing, but remains an experimental series, and plays no part in the official monetary targets.

The Eurozone

The European Central Bank targets CPI inflation, at or a little below 2%. As mentioned above the harmonised measure that Eurostat produces does not include any measure of housing other than actual rents, with a weight of 6%. If you think house price inflation (or deflation) is important for policymakers this low weighting has probably never mattered since the Eurozone came into existence. Although there have been pockets of very high house price inflation (Spain, Ireland, Netherlands) because the Big 3, Germany, France and Italy have had very little house price movement I doubt that a CPIH measure would be terribly different. We are, however, now seeing some upwards movements in the German residential property market in “prime” regions – albeit it as Spanish and Dutch house prices continue to freefall. It’s also important to note the range of importance of rents within the individual countries’ CPI numbers. For Slovenians it makes up 0.7% of their inflation basket, but for the Germans it is 10.2%.


Housing makes up 21% of the headline CPI. Like the US CPI the Japanese statistical authorities use a measure of an “imputed rent of an owner-occupied house” as well as actual rental costs. Again the imputed rents from owner occupiers (15.6%) dwarf the actual numbers from renters (5.4%) – aren’t these large weightings to imputed rents here and elsewhere a bit worrying? How would you homeowners reading this go about guessing a rent for your property? I’d only get close by looking at websites for similar places to mine up for rent nearby. Is that cheating?


So why does this matter? Well if there is no correlation between house price inflation and consumer price inflation then it probably doesn’t. But intuitively both the direct impact on wage demands of workers who see house prices going up, and the wealth effect on the consumption of those who see their biggest asset surging in value should be significant. Therefore central banks will be missing this if they use statistics where the relationship between house prices and their impact in those statistics is weak.



Australian sport as a lead indicator for the housing market

Being an Australian sporting fan hasn’t been easy during my time at M&G over the past five years. The Olympics, rugby, cycling, cricket, tennis… Britain’s golden-age of sport has coincided perfectly with the decline in Australia’s sporting prowess. On top of this, I had the misfortune of seeing my premier league team get relegated last season (though there are definite green shoots of recovery emerging for QPR) and I am about as excited about the upcoming Ashes series as someone who has just been told that they need root canal surgery.

It has now got to the stage that my British colleagues – with memories of their national sporting teams’ performances during the 90s in the back of their minds – have taken pity on me, stating that it’s all cyclical. It’s enough to make you cry into a snakebite down at the Walkie (there’s only one left in London!).

One thing that hasn’t been cyclical is the Australian housing market. House prices seem to go only one way, and that’s to the moon. Australians haven’t had much to talk about on the sporting front in recent years, so most of the chat at BBQs has turned to properties (“How many do you own?”) and prices (“Get your feet on the housing ladder”). The increase in Australian house prices far exceeds the land of sub-prime loans (the US) and goes some way to explain why Sydney, Melbourne and Wollongong are more expensive on a median multiple basis than New York, Miami and Washington.



Twenty-one years of sustained economic growth, low unemployment and the boost to incomes that has come from a record increase in Australia’s trade, have lulled most of the population into a false sense of security that house prices will never go down. There is a well-known rule in Australia for property investing – prices double every 7-10 years. Absolute madness. Throw into this economic bonfire the most favourable tax treatment of property investments in the world and record low interest rates and it’s easy to see why there is a clamour to own bricks and mortar. Not only as a source of shelter but also as a retirement policy. The blinkers have been well and truly fixed to the Aussie home buyer.


We have written before that the Australian housing market worries us (see here, here and here). And with confirmation last week from the regulator that Australian financial companies have lent $1.13 trillion AUD in residential loans to facilitate the increase in house prices we are even more worried. In the background, national papers have been reporting that auction clearance rates have been higher than 80% for almost two and half months and that Chinese buyers are increasingly entering the market due to government restrictions on purchases at home.

The regulator must keep an eye on debt levels and the quality of banks loans to individuals. In Q2 2013, financial institutions lent $79bn to home buyers. $31bn of this was interest-only and low-documentation lending. As we all know this is the area where mortgage delinquencies will first occur in an economic downturn. In Australia, there is a close relationship between debt/GDP levels and house prices. Should the banks be forced to rein in lending, we could see some big ramifications for the housing market pretty quickly.


Australian housing is showing all the signs of a bubble. When lenders start resorting to the cute little kid to shift 95% loan-to-value mortgages you have to wonder how much longer this can go on.

How has the Reserve Bank of Australia (RBA) reacted to this asset price bubble and the risks that it poses to financial stability? By stating that there is no bubble. Dr Malcolm Edey, who is responsible for financial stability at the RBA, stated last week that: “We’re in one of the higher-than-average periods at the moment, but we shouldn’t be rushing to reach for the bubble terminology every time the rate of increase in house prices is higher than average, because by definition that’s 50 per cent of the time. You’re just going to be unrealistically alarmist by making that call every time that happens.” So it appears the RBA, much like the Federal Reserve in the US under Alan Greenspan, would be very hesitant to raise rates to reduce any “froth” that may develop in areas of the Australian housing market.

It is easy to see why the RBA would avoid such an action. Higher rates, in a world where interest rates are near zero in the developed markets, would drive the AUD higher and reduce whatever little competitiveness the manufacturing and export sector had after years of an overvalued AUD in a globalised economy.

The catalyst for any house price correction in Australia will be the labour market. And leading indicators aren’t great. The Australian Institute of Mining and Metallurgy released a report yesterday showing that unemployment amongst its members had increased from 1.7% in July 2012 to 10.9% in July 2013.

Unlike the RBA, we think that it is time to be alarmist, particularly given our concerns around China. More than a decade of digging stuff up and shipping it to China has left Australia with all the telltale symptoms of Dutch disease. The mining industry is not only one of the largest employers in the country, it is famously one of the best paying as well (who hasn’t heard the anecdotes of cleaners being paid $100k a year to clean the miners living quarters?). Should the resources boom fizzle out, as it most likely will in conjunction with a China slowdown, hundreds of thousands will face losing their jobs across the economy. Not only that, we will see a massive impact on consumption within the economy as consumers tighten their belts to try and pay their ultra-high mortgage payments (Aussies will have to quickly deploy the savings they have been building up – the household saving ratio has increased from -2.4% in 2002 to 10.8% today). With unemployment and mortgage defaults rising, the RBA will hit the zero interest rate bound and embark on quantitative easing quicker than you can say “why didn’t we see this coming?”

Most economists see an orderly rotation away from the mining sector as the driving force of the economy to the services sector. The main reason they point to is that a sharply lower AUD should allow sectors like manufacturing and tourism to thrive again. In terms of the housing market, many point to significant under supply and full recourse loans as protection against a meaningful correction in Australian house prices to saner levels. The consensus expects modest gains in house prices for the foreseeable future.

Personally, I am not so sure. Can we really expect a hollowed out manufacturing sector to soak up the excess workers that the mining sector is shedding at a record rate? Remember when central bankers told us the sub-prime crisis was contained? Or the tech boom of the late 90s when everyone was an I.T. expert? Or perhaps it was that developments in Thailand were unlikely to spread and affect developed markets in 1997?

I’ll put my hands up; I’ve thought that a meaningful correction has been coming for at least the five years I’ve been in London. But I haven’t been as convinced as I am today that we are close to the end. There is enough evidence to suggest that Australian central bankers and policymakers should be greatly concerned and the absence of any meaningful debate in the recent election suggests there is limited political will to address any housing affordability problems that Australia is experiencing. I am amazed that young people all over Australia have not made more of an impact on the national debate on house prices. But then again, those born in the 80s and 90s think that rising house prices and economic prosperity is a way of life, so why not borrow eight times your income and leverage yourself up to buy your first house? You can always sell it in five years’ time and buy a better one.

Australia’s national sporting teams may recover from their current downturn. Hopefully the cricketers will in time for the Ashes which begin in November. Whether the Australian economy can survive the double-whammy of a China slowdown and housing correction is another story.


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


The Fed didn’t taper – what’s next for US monetary policy and bond markets?

Last night the Federal Open Market Committee (FOMC) delivered a massive surprise by deciding to not taper QE. For us, this isn’t a huge deal. Since May, the market has placed way too much emphasis and concern over tapering and lost focus on the fundamental economic situation that the US has now found itself in – an economy where unemployment has fallen to 7.3% (helped by a falling participation rate) and a central bank that remains dovish due to a declining trend in core inflation. Now we are through the Fed meeting, arguably the market will now re-focus on the economic data. With interest rate policy set to remain very accommodative for a long period of time – even after balance sheet neutrality has been achieved – the sell-off in government bonds may be close to coming to an end (as witnessed by the 19bps fall in the US 10 year yield from 2.89% yesterday afternoon to 2.70% this morning).

US 10yr bond yields during quantitative easing

Fed concern number 1: US core PCE inflation is flirting with historic low levels

It is well known that FOMC Chairman Ben Bernanke, a student of the US economic depression of the 1930s, has great concerns about deflation and in 2002 gave a speech outlining how the US could avoid a deflationary trap which gave him the moniker “Helicopter Ben”. In the speech, Bernanke makes the important statement that “…Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation.”

The Fed’s preferred inflation measure, the core PCE, is exhibiting a worrying downward trend. This greatly concerns at least one member of the FOMC – St. Louis Federal Reserve Bank President James Bullard – who believes the FOMC should have more strongly signalled its willingness to defend its inflation target of 2 per cent in light of recent low inflation readings. The Fed minutes from the June meeting (at which Bullard dissented) showed that Bullard believed that the Fed was not doing enough to protect against the threat of deflation and that the FOMC must defend its inflation target when inflation is below target as well as when it is above target.

A key component of the Fed’s dual mandate – price stability – is clearly below where the FOMC wants it to be. There are big risks to reducing stimulatory monetary policy when core inflation is running at recessionary levels and on this measure suggests any interest rate hikes a long way away.


Inflation trending lower on both total and core PCE

Fed concern number 2: the labour market

The latest payroll report was weaker than market economists had become used to, with payroll growth averaging around 148,000 over the past three months. This is some way off the 200,000+ numbers that the consensus was expecting earlier in the year and confirms a deceleration in the trend in nonfarm payroll growth. Yes, the unemployment rate fell to 7.3%, but this was largely the result of the labour force shrinking and a decline in the participation rate in August. The labour market is not as strong as the headline number suggests.

Arguably, the fall in the unemployment rate has surprised most Fed members. Nonetheless, unemployment is not expected to fall to the 6.5% “think about raising interest rates” level until late 2014. It would have been a confusing message to start to implement tapering given the lower trend in job creation. The Fed reiterated that the economy and labour market have to be strong enough before in contemplates reducing asset purchases going forward. This helps to explain why the FOMC sat on its hands in September.


Unemployment rate quickly falling towards Fed thresholds

Fed concern number 3: the increase in mortgage rates

Following the moves in markets over the summer, the average rate for a 30-year fixed mortgage has now increased to around 4.5% from 3.4% in May. Essentially, the market has already tightened for the Fed. The housing market is a vital component of US economic growth, and this increase will cut into housing affordability. It could also force potential homebuyers out of the market. A slowing housing market means fewer jobs, less consumption, and lower growth. The increase in yields in the government bond market has been brutal, and does pose some risks to interest-sensitive sectors.


The rise in 30 year mortgage rates will concern the Fed

Given the above, it appears that the Fed refused to be bullied into tapering today by the bond markets, though tapering speculation may have reduced the “froth” that had developed in risk assets over the first half of 2013. It is likely that low inflation, a recovering labour market, and a slowing housing market will ensure that interest rate policy remains accommodative for the foreseeable future. The “Fed fake” suggests that tapering is truly data dependent and not predetermined. Macro matters.

As the market begins to refocus on the economic data, it is likely that government bonds may find some support. Additionally, the FOMC may reduce bond purchases slower than anyone currently expects. We expect that market concerns over the impact of tapering decisions will likely diminish over time as the Fed slowly and gradually moves towards a neutral balance sheet policy next year.


Full time, not part time, economic recovery

When meeting UK clients we obviously spend a lot of time discussing employment and the relative strength of the UK economy. The chart below from the Bank of England shows the recovery in employment in comparison to previous recessions. It actually looks quite good versus the other mega recessions.

UK employment is well above previous recession levels

One very good common question we often get is along the lines that the employment number is “not real” as part time employment has gone through the roof.

The chart below shows part time employment as a percentage of the total number of workers in the UK. There is obviously an ongoing trend to part time employment that has continued from the peak of the crisis. It appears that part time employment increased relatively rapidly through the recession. However, since 2010 the ratio has been declining. Therefore the recent recovery in employment appears genuine and not flattered by part time workers.

Part time employment has moved sideways since 2010

The UK economic recovery is real, and thankfully fiscal deficits, and interest rate policy have worked. The market’s fears of permanent recession are diminishing as reflected in the current bear market for UK gilts. The economic panic illustrated by very low yields where gilts became very dear (see this blog from January 2012), is over. The gilt market yield is returning towards better value, with ten year yields once again around three percent, as the UK economic recovery remains firmly on track.


A little less conversation and a little more action. Gilts underperform and sterling rallies when the BoE speaks

“Now, much has been made of the upwards movements in market interest rates since our announcement of forward guidance and I would like to give you my perspective. There’s been a generalised upward movement in long term bond yields, across the advanced economies, including the UK, over the course of the past month.  The main common driver is speculation that the US Federal Reserve will soon reduce the pace of its asset purchases (and) …. liquid sovereign bonds of the world’s largest economies are close substitutes for each other”.

Bank of England Governor Mark Carney in the “Jake Bugg” speech, Nottingham, 28th August.

In other words, according to Mark Carney, gilts sold off because treasuries sold off. Personally I do not share this view, and feel some of the blame also lies with the Bank of England. Indeed, if we look at the aftermaths of the 4 occasions of Carney writing or talking about forward guidance (the August Inflation Report, the Nottingham Speech, the BoE Monetary Policy Committee Meeting, and at the Treasury Select Committee), we see that in each instance the pound appreciated markedly and gilts underperformed.

Put together, the result so far of forward guidance has therefore been a tightening in UK monetary policy – Governor Carney said last week that monetary policy has become more “effective” as a result of guidance.  Perhaps, but only if you thought the UK was overheating, and this does not appear to be his, or other MPC members’, position.

7th August: the Inflation Report is published.

The August Inflation Report contains the forward guidance that the Chancellor commissioned in the Budget.  It said that rates would be no higher than 0.5% until unemployment was down to 7%, and that the Asset Purchase Facility wouldn’t shrink.  But it contained the three killer knockouts – that you could ignore forward guidance if the Bank’s forecast of inflation rose to 2.5%, if market/consumer inflation expectations became unanchored, or if there were risks to financial stability as a result of low rates. The market focused on these knockouts rather than the unemployment promise. Sterling rallied and gilts underperformed both US Treasuries and German bunds.

Carney intervention 1 - Quarterly Inflation Report

28th August: the Nottingham speech.

There was no mention of the famous knockouts in this speech and the tone tried to be dovish.  But there was a repeat in both the performance of the currency (a rally) and the gilt market (an underperformance).  These same trends are also exacerbated when the Bank of England’s MPC makes its “no change” rate/QE announcement on 5th September without any attempt to reinforce the commitment to forward guidance.

Carney intervention 2 - Nottingham speech

Carney Intervention 3 - BoE MPC Meeting

12th September: the Governor and MPC members appear in front of the Treasury Select Committee.

Not so strong this one – there was a reaction initially from sterling, and to a lesser extent gilt spreads.  But they weren’t especially long lived.

So I have no sympathy for Mr Carney’s view that forward guidance isn’t working because of the adverse movements in the pesky international bond markets – gilts have underperformed both bunds and treasuries, and the appreciation in the pound suggests that the markets think that Carney’s central expectation of three years without a hike is wrong.   But in the Nottingham speech, Mr Carney also suggested that another explanation for rising gilt yields is that “the markets think that unemployment will come down to 7% more quickly than the Bank does…that would of course be welcome”.  This is credible.  We look at economic surprise indices, and it is clear that around the time of the publication of the August Inflation Report, the UK economic data started to not only surprise on the upside, but to be even more upwardly surprising than the (also better than expected) economic data coming out of both the Eurozone and the US.  It’s a combination of the lack of clarity around the knockouts (made worse at last week’s TSC – I recommend you go along to watch this live if you get the chance by the way) and an expectation that the Bank’s unemployment forecast is overly bearish.  Of course the rise in international yields is important, but it’s not the full story.

Carney Intervention 4 - Carney faces TSC

UK economic data stronger than in US and Europe

So the timing of sterling rallies and gilt underperformance around the time of Bank communications suggests that they ARE getting something wrong, and the grilling in front of the TSC did not go well.  If I were them I wouldn’t try to use open mouth policy to try to reverse the trends we’ve seen, as it could lose them more credibility were the markets not to react positively.  Doing something is another matter though, and could lead to a big reversal in the gilt and currency markets.  As UK economic data improves and surprises on the upside I doubt we’ll see anything yet – but we do need a little less conversation and a little more action.

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Jobless claims and Fed policy

Today’s release of jobless claims shows that the US economy is continuing its healthy response to the stimulus provided by the Fed. Momentum in the US labour force remains in a positive direction.

The very long term chart below shows today’s headline number of 331,000 to be relatively low historically. However, this is actually understating the current strength of the labour market.


In order to interpret the jobless rate more effectively we need to look at it as a percentage of the ever increasing labour force, and not just the headline number. We have made those adjustments in the chart below.


The fact that the economy has thankfully responded to low rates is good, though not new, news. However, the one thing that is very different this time is where we are in the interest rate cycle. At previous lows in jobless claims the Fed has typically been tightening to slow the market down. This time they are still in full easing mode with conventional and unconventional policy measures. This contrasts dramatically with the lows in jobless claims in the late ’80s and the beginning and the middle of the last decade, when the Fed was already in full tightening mode. This is highlighted in the chart below.


As you would expect to see, interest rate policy works with a lag. Given that we are unlikely to see conventional tightening for a while, one would expect the US economy to remain in decent shape.

A bear market in bonds can be seen as predicting a future normalisation of rates. If, like the Fed, you recognise that this time around things are not all normal, then you could expect short rates to stay low and employment growth to continue. The extent of the current bear market in bonds is therefore limited by the new environment we are in, where conventional economic systems have been amended and changed by the financial crisis.


It’s a knockout – why the gilt and currency markets have no love for Carney’s forward guidance

Millwall FC wasn’t the only team to trek up to Nottingham yesterday from London and to come back empty handed (at the hands of the mighty, mighty Forest).  Team Carney from the Bank of England also had an unproductive time of it in the East Midlands as the new Governor gave his first speech in the role to the CBI, Chamber of Commerce and the Institute of Directors.  Since the publication of the August Inflation Report, in which the Monetary Policy Committee delivered its framework for forward guidance, the markets have done the opposite of what the Bank had hoped for.  The gilt market has sold off – not just at medium and long maturities, which are largely outside of direct Bank control and are more dependent on global bond market trends, but also at the short end, where 5-year gilt yields have risen by 20 bps in under a month.  There has also been a de facto tightening of UK monetary conditions through the currency.  Trade weighted sterling is 1% higher than it was before forward guidance came in.  Both the gilt market and the pound went the “wrong” way as Carney discussed forward guidance yesterday afternoon.  The Overnight Index Swaps market (OIS), which prices expectations of future official rate moves, fully prices a 25 bps Bank rate hike between 2 and 3 years’ time.


So why don’t markets believe Mark Carney?  In yesterday’s speech he was clear that the UK’s economic recovery was “fledgling”, and weaker than recoveries elsewhere in the world.  He spent some time discussing how a fall in unemployment to the 7% threshold would mean 750,000 new jobs having to be created, which would take some time, possibly three years or longer.  And even if growth picked up, it didn’t necessarily follow that jobs growth would be strong.  But two things led gilts lower yesterday afternoon.  Firstly there was the announcement that UK banks would be able to reduce the amount of government bonds that they hold as a liquidity buffer so long as their capital base is over 7% risk-weighted assets – potentially triggering sales of tens of billions of gilts over the next couple of years.  But more importantly, Carney’s attempted rollback from the “knockouts” stated in the Inflation Report was not strong enough.

On page 7 of the Inflation Report, after detailing the forward guidance linking rates and asset purchases to the 7% unemployment rate, there are three “knockouts” which would cause the guidance to “cease to hold”.  The first knockout is the most important.  If CPI inflation is, in the Bank’s view, likely to be 2.5% or higher in 1 1/2 to 2 years’ time then the unemployment trigger becomes irrelevant.  The other two knockouts were that medium term inflation expectations become unanchored, and that the Financial Policy Committee judges that the monetary policy stance is a significant threat to financial stability.

So for all the talk of the UK’s weak economy, and the accommodative stance that the Bank will take to allow the unemployment rate to fall to 7%, perhaps over many years, don’t forget that if CPI inflation looks likely to be at 2.5% or higher, the MPC will ignore the jobs market promise.  Since the middle of 2005, UK CPI has been at or above 2.5% most of the time, through a strong economy and (for longer) the weak economy.  Since the start of 2010 there have only been 3 months of sub 2.5% year-on-year CPI.  And in 2008 and 2011 the year-on-year rates exceeded 5%.


Of course, the Bank of England can forecast inflation to be whatever it likes over the next 1 1/2 to 2 years.  Its inflation forecasts have famously been awful for years, always predicting inflation would return to 2% when it always was much higher than that.  But it will be important for Carney to earn some credibility here in the UK, and the days of the Inflation Report’s “delta of blood” inflation forecast always showing a mid point for future inflation of 2% must surely have ended when Mervyn King left.  What does the outside world think about the prospects of UK inflation being below 2.5% in the future?  Here the news is better – the consensus broker economic forecast is for CPI to fall to 2.4% in 2014 and 2.1% in 2015.  And the implied inflation rate from the UK index-linked gilt market is for an average of 2.8% per year over the next five years on an RPI basis, which given the structural wedge between RPI and CPI suggests that the market’s CPI forecast is somewhere below 2.5%.  M&G has launched a new Inflation Expectations Survey, together with YouGov.  We should have August results shortly, but in our last release we saw that 1 year ahead UK consumer expectations of inflation ran at 2.7% (a fall from 3% a quarter earlier) and 5 year ahead expectations were at 3%.  Higher than the 2.5% target, but consumer expectations are often higher than the market, and the 3% level has been stable (well “anchored”).

But as we have seen, UK inflation has been notoriously sticky.  Not because consumers are demanding more goods than the shops can supply (although there has been some long awaited good news from the retail sector lately, with sales stronger), as in general real incomes have been squeezed and discretionary spending has been hit.  But because non-discretionary items, like food and energy costs, have substantially exceeded the inflation rates of consumer goods.  Add to this administered prices relating to public transport costs or university tuition fees and we can see that the UK’s “inflation problem” is potentially something that a monetary policymaker can only influence by forcing discretionary spending into deflation.  The chart below shows that so long as the non-discretionary basket of goods keeps inflating at around 5% per year, there must be virtually no inflation in discretionary goods in order to get below Carney’s 2.5% knockout.


So it is going to be tough for the market to believe that the CPI inflation “knockout” won’t have a decent chance of coming into play well before the 7% unemployment threshold is reached.  I think Carney missed an opportunity to move away from the knockouts yesterday – he certainly didn’t use the term again, and implied that the gilt market’s move lower was driven by international developments and over-optimism about the prospects for a quick fall in UK unemployment.  But the three knockouts were almost dismissed in the sentence “provided there are no material threats to either price or financial stability” rather than given the prominence that they were in the Inflation Report.  But it looks as if the gilt and currency markets need something stronger if they are to produce the monetary easing that, from Carney’s bearish analysis of the UK economy, it still needs.


A roadmap for Europe after the German elections

August is usually a dull month in German politics. It’s holiday season, and national parliamentary politics takes a break at the same time. However, this year German politicians don’t have time to put their feet up. The period of parliamentary recess marks the peak of the electoral campaign in Germany before the general elections take place on 22 September. Many people seem to expect that not only will the holiday period end in September, but also the recent lull in European politics. The hope is that the European Union, and the Eurozone in particular, will finally move on to sorting out its structural issues once the German elections are over. I’m not really convinced that this is going to be the case, and here is why.

Not much upside from a shift in policy

Angela Merkel has indicated she would like to renew the current coalition with the liberal FDP after the general elections in September, while the Social Democrats (SPD) and Greens strive for a remake of their 1998/2002 electoral victory. Merkel’s Christian Democrats are currently far ahead in the polls, but a renewal of the coalition with the stumbling FDP is highly uncertain. On the other hand, a coalition of SPD and Greens looks as probable as an English victory against Germany in a football tournament through a penalty shootout. This could leave the two major parties, CDU/CSU and SPD, with the choice of immediate snap elections or a grand coalition. I tend to believe that they would not ignore the electoral will of the German people who remain very open towards the idea of a grand coalition. The recent figures from one of the major German polls, the ARD-DeutschlandTrend, suggest that 23 per cent would prefer a coalition of CDU/CSU and SPD, while the parties’ preferred coalitions qualified for 17 per cent of the poll votes each. In addition, around half of the Germans have consistently described a coalition of CDU/CSU and SPD as a very good or good option over the past few months. If CDU/CSU supporters are left with a coalition choice between Greens and SPD under the assumption of a shortage of combined votes with the FDP, then polls suggest a strong preference for the SPD. That is, the most likely coalition options after the general elections seem to be: CDU/CSU and FDP (existing coaliton) or CDU/CSU and SPD (grand coalition).

It stands out in the current electoral campaign that Europe has not been a major topic. European politics does not feel like a policy area where the major opposition party SPD can win votes or would be able to distinguish itself sufficiently from the government’s policy stance. This has also been reflected by the previous legislature period when the opposition parties widely tolerated Merkel’s course on Europe. Bearing the previous policy stance as well as the current polls in mind, I struggle to find strong arguments why a new German government would fundamentally change European day-to-day politics. I expect a continuation of the pragmatic approach of austerity-focused, but sufficiently accommodative steps to keep the Eurozone together, including another bailout package for Greece that treasurer Schäuble hinted upon. Thus far, this political approach has proven to be fairly successful domestically. It feels that it’d require a major game changer to trigger an immediate change in policy. It seems more likely that any political developments with regard to Europe may rather be undertaken with a long-term time horizon.

Deeper European integration could require a referendum in Germany

While a newly elected German government might find it politically too costly to redefine European day-to-day politics, it could also struggle to conclude long-term structural reforms – ranging from Euro bonds, more centralised European governance of national budgets to full political and fiscal union. The president of the German Constitutional Court, Andreas Voßkuhle, pointed out in 2011 that the German Constitution does not allow for further significant European integration. He concluded that the additional transfer of national sovereignty to the European Union, eg the national budget, would require a referendum. This is very noteworthy as Germany has not had a referendum in its post-war history despite the adoption of a new constitution, membership in the European Union as well as the re-unification of East and West Germany. The preparation of a referendum takes a significant amount of time, and the selection of a date is a sensitive issue. In this instance, it might also take time to explain to the public why the proposed structural changes, eg a political and fiscal union, would be in their long-term interest and how it would affect their life as national citizens. The referendum would most likely be based on the adoption of a new European Union treaty which would provide for the future design of European politics and governance. The ratification process and enactment of the last EU treaty, the Lisbon treaty, took more than five years from June 2004 to December 2009. Factoring for some potential political goodwill this time, wouldn’t the next German general elections in 2017 be a reasonable point in time to ask the political parties to communicate their positions on the subject and to let voters subsequently decide upon their future within Europe (or outside)?

Policymakers are unlikely to bear political and fiscal costs amid uncertainty

This may sound familiar to our British readers whose Conservative party has already announced its intentions to call for a referendum on Britain’s future in the European Union by 2017. In the UK, the Conservative party’s commitment to 2017, as well as the prospect of an indispensable referendum in Germany (and elsewhere in Europe), might have set a reasonable deadline for European leaders to develop a concept for the future institutionalisation and integration process of the Union, including the Eurozone. This could then be ratified across Europe, including Germany. Not 2013, but 2017 could mark a historically important year for European politics as national voters could be asked to re-commit to a deeply integrated (and burden-sharing) Europe. If such a scenario for Europe turns into a national government’s base case, it will be difficult to picture these policymakers agreeing on politically and fiscally costly policy measures that go beyond the current pragmatic attitude towards Europe. This argument could not only hold with regard to the aforementioned countries – Germany (anything beyond emergency bail-outs for Eurozone peers) and the UK (financial regulation and EU banking reform) – but also for governments that currently face a strong headwind in the polls. A very recent example is the political situation in the Netherlands where the current government would be dwarfed to a vote share of 23 per cent from a share of 53 per cent in last year’s elections, while the right wing and euro-sceptical party PVV has gained around 10 per cent in electoral support.

If I had to draw a roadmap for Europe until 2017, then the first part of this political journey would carry significant risk of a slow moving city traffic experience, but which could ultimately end on the high-speed Autobahn.


Lower for longer – the path to Fed tightening

The disclosure of the latest Federal Open Market Committee (FOMC) meeting minutes last night has pushed the US bond market to new lows for the year, further extending the current bear market in world government bonds. Looking at what the Fed is doing is nothing new. Back in the day when I first started, we had dedicated teams of Fed watchers, trying to work out its next move, as rate changes were frequent and unpredictable. The current policy is to make less frequent changes and be more transparent. So what does the FOMC’s forward guidance by providing its internal thoughts tell us today?

The committee knows that what is discussed will affect the markets, so a stylised version of its discussion needs to be produced. The release of the minutes is a manufactured and glossy disclosure of its work presented to make the FOMC look good and influence its followers. So what was the message from last night?

Well, it is more of the same about the need to tighten as we previously blogged here. The Fed continues to follow the script. The basic scenario is that they need to get the party goers out of the bar with the minimum trouble. This is why the Fed is keen for us to see that they discussed reducing the unemployment threshold at the last meeting. This is akin to saying ‘drink up’ to a late night reveller, with the hint that once they’ve done so there is a chance the bar staff will pour them another drink.

The Fed wants a steady bear market in bonds in this tightening cycle as it is still fearful over economic strength and fortunately inflationary pressures remain benign. This is very different from major tightening cycles in the past such as 1994, when the Fed was more keen to create uncertainty and fear in the bond market as they wanted to tighten rapidly and were still fearful of inflation given the experience of the 70s and 80s.

So when will official interest rates go up? Strangely you could argue that the successful creation of a steady bear market in bonds extends the period they can keep rates on hold. Monetary tightening via the long end reduces the need for monetary tightening in the conventional way. For example, as you can see from the following chart, the 100bps or so sell-off in 30 year treasuries since May has translated into a similar move higher in mortgage costs for the average American.

22.08.14 30y mortgage costs

If the Fed has its way in guiding a steady bear market in bonds, then bizarrely short rates could indeed stay lower for longer.

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