It’s not 1993-1994 in the government bond markets. Unemployment is still way too high to provoke a Fed hike. But the Bank of England might be on the brink of a policy error…

US Treasury Bond Market in ‘93 -‘94
Government bonds have been selling off over the past month. Since mid October the 10 year gilt yield has risen from 2.85% to 3.63%, the 10 year bund from 2.25% to 3.00%, and the 10 year US Treasury from 2.40% to 3.40%.  The damage has been even greater in peripheral Europe – Spanish 10 year yields are up by nearly 150 bps over that same period.  Part of this reflects the return to a “risk on” world, where equity valuations looked compelling as the economic data came in generally stronger than expected, leading to less demand for safe haven assets – especially as those safe haven assets were trading around record low yields.  The other important part of the move is about a rise in inflation expectations. This had already started in mid 2010, as commodity price inflation (for example cotton, coffee, energy) had taken off, but the move was exacerbated by the US Fed’s announcement of QE2 in early November.  5 year inflation expectations as derived from TIPS yields have risen from a low of 1.13% at the end of August to 1.95% now.  Add to this fears about sovereign creditworthiness (others have now joined us in worrying about the US’s AAA credit rating, and Europe faces its own default crisis) and it is no wonder that bond yields have risen.  Might this be a re-run of 1993/1994, when government bonds rallied hard in 1993 before the Fed unexpectedly hiked rates in February 1994, provoking a 200 bps sell off in 10 year Treasury yields?

I went back to look at the economic environment at the time, to see how different it was to today.  The thing that surprised me was that inflation had been steadily falling throughout 1993, both on a core and a headline measure. It didn’t start to pick up until the second quarter of 1994, after the Fed had hiked. 

The inflation picture is similar now – the starting point is lower, but actual inflation had been coming down throughout 2010, towards record lows on the core measure.  So when the Fed hiked in 1994 they were doing so in a falling inflation environment.  What is different is the employment situation.  In 1993 the unemployment rate was falling decisively, and was at a much lower level than it is today – i.e. the unemployment rate was falling towards 6.5%, with some estimates of full employment at just under 6%.  The US currently has an unemployment rate of over 9%, and whilst it may have come off its peak, it is miles away from full employment.  In fact some would argue that the unemployment rate is understated at this point thanks to a significant fall in the labour force participation rate, as discouraged workers stop looking for jobs, the young go back into education, and people retire early.  Over the past couple of years the participation rate has fallen from 66% to 64.3%, compared with over 66% in `93/`94.

We think the Fed is still massively more worried about the jobs situation than it is about generating inflation.  We’ve been following the chart on the left for years – it shows that the Fed’s reaction function means that they wait for unemployment to start falling on a sustained basis before they start to hike.  In the last two cycles the lag was a year to twenty months from when the unemployment rate started to fall.  You could argue that US unemployment did start to fall towards the end of Q1 last year, which means that the Fed might hike later this year.  But in our view the level of unemployment is still way too high, and the fall in the participation rate is too severe.  In any case, in the US you can rule out an early 2011 rate hike.

Is that also true in the UK?  Unemployment here is sticky too, just below 8% on the ILO measure.  And the public sector job cuts are yet to bite.  But inflation is very sticky here and the Bank of England has missed its 2% CPI target and been at or above 3% for all of 2010.  RPI inflation is at 4.7%!  The 2.5% VAT hike will start feeding into retail prices from this month onwards, and utility and petrol prices are rising sharply.  The money markets are already pricing in two 0.25% rate hikes in the UK this year, with a small chance that there will be a third rate hike by year end.

Rate hikes would kill core inflation (although remember that mortgage rates are a component of RPI, so that measure of inflation would likely rise with every rate hike) – but they would also be GDP-suicide in this fragile economy, bringing deflation risks back into play. Hopefully the Bank still feels it can target future inflation, and has the confidence to ignore those reacting to current inflation newsflow and calling for imminent rate hikes.  But I don’t think that the Bank of England has much breathing room left, and with persistently high current inflation the Bank’s credibility is under attack.  I think we’re only one surprisingly robust inflation print away from a UK rate hike.  Let the policy errors begin…

Discuss Article

  1. Anonymous says:

    But I don’t think that the Bank of England has much breathing room left, and with persistently high current inflation the Bank's credibility is under attack.  I think we’re only one surprisingly robust inflation print away from a UK rate hike.  Let the policy errors begin… <<<

    Unfortunately, the policy errors began many years ago when the BoE decided not only to turn a blind eye to the housing market asset bubble, but to actively intervene on any signs of weakness. A property-centric UK version of the "Greenspan Put", if you will.

    Thus, when that market hit a very slight stumble in 2005, they chose to cut rates in August of that year, action which helped fuel the continuation of the UK's property bubble for a further two years beyond the point when the US housing market commenced falling.

    So, through their actions, they’ve set out their store as primarily defenders of housing asset prices, not their actual core remit of inflation guardians. Hence, we have the situation now where their rate decisions are used to justify their (ever more flawed) forecasts, rather then the other way around. It's almost become embarrassing.

    Certainly, belief is rapidly evaporating that inflation targeting is really their prime goal. And to regain credibility may require decisive action from them, with the possibility of quite unfortunate effects.

    But be under no illusions, this situation is entirely of their own making through a prior catalogue of forecasting and policy errors.

    Posted on: 13/01/11 | 11:02 am
  2. Justin Pugsley says:

    The Bank of England is in between a rock and a hard place on this one. Clearly the UK has an inflation problem, largely caused by external factors such as soaring commodity prices, but hiking interest rates like it should under these circumstances will hurt the fragile economy, mainly in terms of confidence.

    Therefore the BOE is taking the economic situation into account; part of its remit is to support the government’ economic policies, such as boosting growth, as well as the 2% inflation target.

    But I wonder how long the BOE can ignore rising inflation, at some point that in itself will hurt the bond market- so it is possible that a rate rise would be taken as a sign that the UK is getting serious about inflation by raising interest rates and that could strengthen the bond market, particularly if it boosts sterling and there’ a perception that rates will still remain relatively low. My feeling though is that BOE will get blamed whatever it does either for allowing inflation to rip or for killing the economy. Maybe that idea by one BOE member to raise interest rates &amp; do QE (by buying gilts) simultaneously is a good half way house, but somehow feels contradictory.

    Posted on: 13/01/11 | 11:14 am
  3. J T Foreman says:

    Anonymous is right: the BOE is rapidly becoming an embarrassing laughing stock.

    Either we have inflation targeting or not. Just the potential of deflation (they meant below-target inflation) was enough for the BOE to crash its base rate instantly in 2008. Deflation never happened (CPI). Yet actual existing above-target range inflation is tolerated time and again, excused and explained away. It's blamed on external factors and taxation. Yet continental Europe has seen similar tax-hikes (Portugal VAT to 23%) and is exposed to those same commodities. Yet it has much lower inflation, until very recent within target-range. So BOE, why is it then higher here?

     

     

     

     

    Posted on: 16/01/11 | 4:42 pm
  4. Pugsley for President says:

    More scintillating analysis from the Pugster!

    Posted on: 17/01/11 | 12:00 am
  5. Steve L says:

    Because the Euro hasn’t suffered as much as Sterling. As much of our inflation is imported the exchange rate probably explains most of the difference.
    What’s our balance of payments like compared to the Euro Zone?

    Posted on: 18/01/11 | 6:12 pm
  6. Anonymous says:

    Interest rate rises at this current juncture would cripple the UK, given we already have the removal of fiscal stimulus the removal of monetary stimulus with a hike shouldn’t be needed, besides,  the current level of inflation is mainly due to tx hikes and commodity prices, neither of which would be affected by raising rates.
    As usual, talking heads that have removed themselves from life’s realities.

    Posted on: 31/01/11 | 4:09 pm

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