Thursday, January 06, 2011

2011 Non-Predictions 3 - Rates

Today TMM move on to their Rates Non-Predictions...

The Bank of England will NOT continue to ignore upside inflation surprises.

Readers will remember TMM is running a crusade against the Bank of England's Mervynflation policy, but there are a few signs that things maybe about to change at Threadneedle Street. Recently, the hawkish group on the MPC has been gaining traction with consistent upside surprises to inflation that are becoming a bit more difficult to shrug off as a result of "one off" factors. Sentance, Dale and Bean have all broadcast their worries about inflation expectations that have been continuing to drift higher (see chart below), especially the fact that professional forecasters have begun to move their medium to long term inflation expectations higher in recent months, when previously these had been anchored firmly at 2% for the entirety of the independent BoE's history.

One of the main differences between the US and UK, something not particularly appreciated by our friends across the pond, is that the UK has a great deal less spare capacity, despite what Professors King and Posen try to claim. Partly as a result of the exchange rate falls and dramatic fall in interest rates, the labour market did not deteriorate anything like what might have been expected for such a deep recession, and a corporate sector flush with cash that has begun to invest and ramp up hiring, both the fall and recovery in capacity utilisation has been very different to that in the US. The below chart shows the deviation of Capacity Utilisation from its mean level since 1985 in units of standard deviation (red line) versus RPI ex-Food lagged 6months (blue line) and is TMM's version of the Output Gap model. Due to time constraints we've not been able to adjust the RPI measure for the VAT effects, but as a rule of thumb, it would probably be around the 3.4% level (75% basket *2.5% =1.88% difference) which is about consistent with the output gap (in terms of the deviation of Capital Utilisation from its mean) at about zero. Anyway, you get the point: there isn't much spare capacity (if any) in the UK right now.

The BoE have been clinging to the argument - which TMM accept is potentially a valid one - that as the fiscal consolidation both domestically and in the Eurozone begins to bite that the economic risks are to the downside. Today's weak Services PMI supports this line of reasoning, but could easily just be due to the weather. As the very talented Ben Broadbent at the Vampire Squid points out, private sector hiring is more than enough to offset the fall in public sector jobs, and this mornings IDS wage settlements data accelerating from 2% to 2.2% suggests that the lack of capacity is beginning to show up in wages. So, unless the data in Q1 disappoint significantly, TMM reckon that the Bank of England will be forced to capitulate and react to the persistent upside inflation surprises and begin a hiking cycle.

9) 10yr US Treasuries will NOT beach their 2010 yield lows, but will also NOT rise above 4%.

In 2010, the market panicked that we might be headed for a double dip recession, sharply marking down 2011's growth prospects both in bond yields (see chart below of the 5y5y forward real UST yield - white line, vs. consensus economist 2011 GDP forecasts lagged 2months). As data has improved in recent months, it looks to us as though the growth scare was merely a mid-cycle slowdown and the economic recovery is becoming self-sustaining. TMM reckon that the only things that could dislodge the recovery would be a complete policy-driven collapse in the Eurozone (someone leaving), or an involuntary restructuring of senior bank debt in Europe (although we would exclude Irish banks from this as there is a widespread expectations that senior creditors will take a bath here), both events that TMM views as rather unlikely.

TMM's long-run fair value model for 10yr USTs, based upon debt ratios, the output gap and medium-long term inflation expectations (see chart below, orange line, 10yr USTs - white line) has yields as close to fair value, and given the output gap is (slowly) closing and the renewed fiscal stimulus will push up the debt ratio, it is hard to see much room for this measure to move much lower...

...persistently low core-CPI (see chart below, lagged 12months - orange line) prints are likely to keep inflation expectations subdued as the output gap (OECD measure - white line) is still very large, predicting core-CPI to only reach about 1.6% by year-end. It is also worth noting that it is rather difficult to get to a 4% yield number without real rates rising significantly (something the Fed is eager to prevent), given that 10yr TIPS Breakevens at 2.4% are already at the highs they were at in April 2010 when 10yrs were trading 3.98%. Add to that the probability that Republicans force Congress to put in place a long-term deficit reduction plan and it is hard to envisage a material break higher in yields. On the back of all that, TMM reckon bonds are range-bound.

10) Spanish 10yr yields will NOT hold below their 2010 highs, but Spain will NOT need a bailout.

One of the consensus trades for 2011 is the continuation of all things Eurobllx and a seeming inevitability that Spain will need to tap the EFSF. While TMM expect a good old fashioned bit of Eurotrashing in Q1, resulting in Portugal running into the arms of the EFSF and a spike wider in Eurobond spreads, they find it hard to believe that EU policymakers would let the next domino fall given the ever-increasing costs of inaction. Indeed, in policy circles, talk of a pan-EU bank recapitalisation fund is amok (as mentioned before, this was always TMM's favoured solution to the crisis because bank capital can be leveraged). Regulators are currently preparing for a new and tougher round of stress tests, and clearly understand that national solutions to the undercapitalisation of national banking systems are untenable due to the extreme pressure they put on the sovereign's balance sheets. The beauty of a pan-EU bank recapitalisation fund is not just that it allows the leveraging of equity (which will create a positive feedback loop in peripheral bonds), but that it avoids a direct bailout of Spain, which would surely push the market to attack Belgium and Italy. In such a format, the pan-EU fund would also be exposed to the upside in terms of a recovery in bank equity and be less likely to result in a backlash in Germany against the Euro, instead, merely adding to the anger against bankers (a convenient distraction for politicians to point to).

We know that plenty of work has been published on Spain's refinancing calendar and the relevant dates are being used by market players as this year's roadmap to Eurodoom. But these dates are just as clear to the Eurostriches and we cannot believe that even they can ignore their oncoming thunder and must have some sort of plan... Surely?


Anonymous said...

US 10Y 3-4% range, agreed. short spain outright agreed too ... heck maybe short belgium long italy at this juncture makes sense.

but whats the trade for the MPC? outright short reds? 10Y gilts? money market steepners? or FX play like short eur-gbp?

cpmppi said...

Yep, I reckon there will be a fantastic opportunity to get long of Italy at some point in Q1.

As far as the MPC goes, I'd be tempted to sell Red short sterling vs. Eurodollars and Euribor. Think Gilts will be pulled two ways as fiscal premia creep into Bunds/USTs and out of Gilts. And EURGBP is too much an "anti-EUR" trade for my liking. Maybe GBPAUD...?

Anonymous said...

well, not so sure i would be buying red euribor vs short sterling but ED's ... so maybe long cable (you may also get benefit of builders rolling mortgages)

generally, it basically comes down to merve the perve as i am pretty confident that he is both happy to inflate debt away and more worried about downside risks of fiscal tightening and bank balance sheets. to me that argue in favor of a steeper money market (whites-greens) ...

great analysis on UK inflation btw!

Anonymous said...

and agree on long GBP/AUD ... especially if you think inflation problem being greater in asia, faster tightening there can't be good for aussie exports.

cpmppi said...

Yep the ED call is easier than ER. And yes, if they start hiking, Cable will roof it.

Yeah, I tend to think that Merv is losing the debate now as Dale and Bean appear to have started to lean more hawkishly.

And glad you liked the inflation stuff!

Anonymous said...

Whilst I acknowledge that the most recent commentary from the MPC members cited was of a more hawkish tilt we do lose Sentance in a couple of months. Wage inflation data the key. Don't believe they will do anything until we have got past April eurozone issuance question and had a look at Q1 domestic developments so Aug inflation round most likely imo. Short a few reds via midcurves and think the gbp/aud makes sense but currently short aud/cad instead.

Anonymous said...

anybody else out there perturbed by the notion that inflation should be a late cycle phenomena yet this time it seems to be at the beginning of country specific "cycles" ... implications?

Anonymous said...

You cant defend both a surging IBEX and very high spanish debt spreads (as today 250 bps).

Both are incompatible.

Polemic said...

Anon 6.04

Well maybe difficult for them to both occur at the same time, even though it is still possible, but we are looking for spanish yield's to blow out one more time DURING the year , but the ibex to have outperformed dax by the END of the year.

Nemo Incognito said...

We might add that post Portugal tapping the EFSF when Spain blows out one last time might be a great time to get some Ibex on. Its silly cheap now but if 2008 taught us nothing else its that buying stuff cheap may guarantee long run returns but won't guarantee you jack for your quarter,

abee crombie said...

what dates are those for the PIGS refinancing.. is it mostly in Q1, Q2?

sorry i dont work on a desk and have it in front of me.

as for rates go, this year looks like the divergence year (UK, Canada, maybe EU start) while uncle ben sticks his head in the sand.. buy ED big dips

Charles Butler said...


January through April for Spain. The guv is claiming that their net issuance will drop from 62 to 47bn for the year. Plans are for all net to be two years and out.

Curious data point is that if one sums central government debt, regional debt, municipal debt and the high end of cataclysmic estimates concerning the amount Madrid would have to put up to roll over maturing bank/caja debt - the result is mighty close to the current debt/GDP of France.

This will turn when it turns.

abee crombie said...

cheers thanks charles.. i guess i have to keep my eye on the spanish auctions still

Charles Butler said...

Near future issues in the last column of the page. 5-year next Thursday, but no word on amount yet.

Charles Butler said...

Or this one looks a bit further out, but it has to be confirmed by the former.