Friday, May 28, 2010
While we are still dominated by the maddening cacophony of month-end flow, let's drill down on the inflation/deflation debate that has been at the core of most of our recent pieces. This time at a specific issue brewing beneath the surface. The Bank of England is allowing an inflation problem to develop in the UK as Merv' the Swerv' has repeatedly attempted to talk down Sterling and interest rate expectations in order to keep monetary conditions exceptionally loose to support the recovery. He argues that there is a very large output gap and that the imminent fiscal tightening and Eurozone austerity plans will weigh heavily on growth. Maybe you're right Merv, but targeting growth alone is not your job. As David Cameron reminded us, this morning, the rise in inflation in recent months is worrying and "rates will be set to control it" and that we "need to make sure that CPI is under control". As some have rightly pointed out, politicians should not meddle with independent central banks. But given the BoE isn't carrying out its mandate properly, perhaps the PM is right to raise the issue. The BoE argue that much of the jump in inflation is FX-related and VAT-related, and yes to some extent this has had an impact, but cannot explain a significant chunk of increase.
Spot the difference: UK core CPI (white), US core CPI (brown), Eurozone core CPI (green)
There is a material risk of inflation expectations de-anchoring, especially given that the BoE appears to be the most dovish major central bank. Earlier in the year when market-based measures of inflation expectations spiked, the BoE toned down its rhetoric. Interestingly, the 5y5y Breakeven (first chart, white line) is back to the highs of the year and looking precarious. Survey measures of inflation expectations have also drifted higher towards 2007-levels, though not yet to the highs of 2008, but with 5%+ RPI prints it is likely that these will continue to move higher, especially given that rates are so low. Sorry Merv, don't think this is sustainable...
It's funny that this time around, there are no calls for the World economy or Emerging Markets to decouple from the Eurozone train crash, in sharp contrast to the consensus view around the US housing market. Given this, rates markets have pushed out tightening cycles globally as economic contagion has been priced in as the Eurozone demand is expected to collapse (hold on a minute, it wasn't that strong to start with...). Anyway, whether or not this view is legitimate or not is irrelevant, the UK looks like it has an inflation problem and the BoE is going to have to do something about it. The below chart shows forward rates for the BoE Base Rate (red), 3m Libor (purple) and spot SONIA swaps (blue). At the 2yr horizon, there is a good chunk of hikes priced in, but still the Bank is only priced at about 1.7%. In reality, there is also a lot of risk premia in the curve so, if anything, market expectations for the Bank rate look very low, and those at the 1yr horizon virtually non-existent. With carry at the front-end now so low, Short Sterling looks like a "yours"...
As Dr Bubacles put it:
"Hanetos, en quilla cobitos, ben neth neck obfeta penetos quentaniqa, heth eth eth eth eth eth eth. F****d inseta inflayshun"