Wednesday, November 09, 2011

A Partial Apology to Merve

This mornings news is firmly "price", and the price that matters is that of the BTP. And it matters because 7% is a magic number in the markets eyes as the last time it got there other countries needed bailouts. So despite their being no other news someone has decided to "have a go" and it's sent our PIN variable nuts. The 9am London drive by saw a machine-gunning of a variety of assets. 26K of eminis , 11k of Dax contracts in a 10min period as well as the obvious. Since then Price Is News has gone into overdrive and the market is expecting Europe to end by teatime. But TMM as usual, micturating into the wind, think that the key is whether this generates further action from Italian politicians and a final acceptance on the part of the Germans and the ECB that they are just going to have to buy more BTPs. Price Is News.

Now, it may sound odd turning our backs on Italy, but considering the deafening roar from everyone else screaming doom about it, at best we wouldn't be heard and at worst we would be blown away in the gale. So we are slamming our windows shut on the storm of mostly unthoughtful rubbish and returning to our writing table in the corner of our garret room to consider something else, far far away from current market fashion.

Regular readers will know that TMM are not the biggest fans of Bank of England Governor Mervyn King. His conduct over the past few years, beginning with refusing to recognise the BoE's lender of last resort responsibility with respect to Northern Rock amongst other things. But TMM reckon they owe the Governor at least a partial apology regarding their prior view that he was letting the inflation genie out of the bottle. In fact, in the context of the past year's developments, they must actually congratulate Merv and the good chaps on the MPC. And *that*, is because they've managed to (so far) pull off something that TMM never thought possible - rebalance the UK economy without losing the competitiveness gained since 2007.

TMM generally were of the view that the inflation expectations-augmented Phillips Curve still reigned supreme, but it seems - remarkably - that this is no longer the case. For whatever reason - TMM assume it to be a combination of the 1980s labour market reforms, coupled with BoE independence - past inflation and inflation expectations appear to have had very little effect upon inflation or wages since the late-1990s. And this is *despite* the fact that since the inflation target was changed to be CPI in 2003, that inflation has averaged an above-target 2.5%, that since the crisis broke out in summer-2007, it has been an average 3.2%, that it has only been below target for a mere six months in the past 48 months, and above the top end of the target range for virtually the entire past two years, hitting an eye-watering 5.2%.

It's not that inflation expectations haven't risen... indeed the BoE's inflation expectations survey (see chart below, white line) shows households expect inflation of 4.2% over the coming year. Markets, by contrast, have been more sanguine , with the 5y5y forward breakeven (orange line, usual caveats apply) having fallen sharply over the summer, but prior to the eruption of financial markets, had too held around the upper range of the past decade.

TMM's view was that in the face of sustained high inflation prints that eventually second round effects would appear, with wages responding to the inability of the Bank of England to meet the inflation target for such a long period of time. However, the Swerve appears to have managed to sell the idea that the reasons for such high inflation are entirely (TMM are less convinced), driven by a combination of the exchange rate depreciation since 2007 and the VAT-hikes. To illustrate, the below chart shows UK RPI ex-Food (blue) vs the weighted BoE Agents Spare capacity measure (red), which shows a remarkable divergence in the driver of inflationary pressure from the usual capacity driver. Even lopping off a few percent points to give a poor man's VAT etc correction should lead one to conclude that these "transient" effects are not the only factor between persistently high UK inflation.

But this has not fed into wages. The below chart shows the same BoE Agents spare capacity measure lagged 8months (red line) vs. Average Earnings ex-Bonuses YoY (blue line) since the BoE was given independence. TMM are amazed that the bulk of wage growth can be explained by this measure alone, and are forced to conclude that BoE independence has removed inflation from wage setters' radars. Indeed, if anything, the media coverage of a weak economy has probably helped contain wages here, and growth has been especially tepid relative to what might be implied from the capacity measure these past six months (probably a result of Eurozone media coverage).

So what has been the result of this? Falling real incomes which have put pressure on domestic consumption and certainly contributed to the somewhat, err, tepid recovery seen since 2009. But it has also meant that the UK has managed to hold onto a good part of the competitiveness gain that resulted from the post-2007 devaluation, by ensuring that UK real wages fall more quickly than those of its competitors [see below chart of UK real wages relative to their pre-crisis 2007 levels (blue line), vs. US (green line) and Eurozone (red line)].

Which, now that the ONS has been able to properly collate the national accounts data for the past couple of years, revising the current account deficit lower, to around -1.75% of GDP which, in the context of the UK Net Foreign Asset position, is probably about right. Some rebalancing, given that it was pushing 4% of GDP back in 2007.

And all of this has happened at the time of deep financial and sovereign crisis in Europe, while the government has been trying to put its own fiscal position in order, Gilt yields have fallen to multi-decade lows (though, admittedly this is partially a result of lowered growth expectations) as foreigners bought a significant chunk over the past few months given the lack of suitable "risk free" alternatives elsewhere. TMM are forced to conclude that this combination of macroeconomic policies (especially those from the Bank) appears to have been exceptionally successful...

...So far. TMM reckon that with the Whites/Reds Short Sterling curve so flat (see below chart of 3rd vs. 7th contract), that there is a relatively low risk way of putting on a trade that performs if wage growth picks up and the Bank are forced to take a less dovish stance in the face of second round effects. Alternatively, perhaps the World might look a lot different with Europe moving towards an eventual solution and the US/Chinese growth engines ramping up. Given that the BoE have this time got ahead of the curve with their latest QE2 round, they would presumably have to move more quickly on a reverse. Of course, this can be vulnerable to Libor-OIS blowing out in the short term, so a less risky way of putting it on would be in SONIA space, though the level is not quite as attractive there. But given that this part of the curve could easily steepen back out to around 120bps, TMM reckon this isn't a bad punt.

But in the meantime, Merv: TMM apologise.


abee crombie said...

I like the trade. And Libor - OIS is at a decent spread now (so if it came in for the 3rd contract it might help out

But 6m & 9m Libor has been stubborn at coming in and getting me kinda worried ...using my GEH2 & M2 proxies

Anonymous said...

I like this analysis. BOE seemed to be ahead of other central banks for now.

But, lets survive through the current Italy bond crisis first. Is it a bit like 'Margin call'? Somebody somewhere saw that the music would stop in the foreseeable future and decided to be the "first" to get out of the door.

abee crombie said...

regarding BTPs, you would think if markets really panic the ECB will step in with a significant purchase.. every other CB is doing it

Is this why the markets are still holding up so strong, the Draghi put?

willem said...

Thoughtful post, as always.
But....Perfect storm - Classic liquidity trap, massive output gap (domestic & global), and a surge in supply of global labor force participation/productivity.
Personally I wouldn't bet on wages picking up inflation pressures anytime soon.

Anonymous said...

So.. basically inflation is what happens when you get a raise...and everybody else gets a raise, and the price tags get a raise.

In contrast when the prices rise, but you don't get a raise, it's just you becoming poorer.

The economy is shit. The spending cuts make things worse. People are grateful just to keep their jobs, feeling too terrified to demand more pay.

And we're supposed to be happy about that?

We truly live in a world of diminishing expectations.

Leftback said...

"We truly live in a world of diminishing expectations."

Absolutely, old chap. In fact if you can make 5-10% a year this decade then you are going to be well ahead of the herd, imo.

We have been waiting for this dollar rally, sitting patiently for the Euro to rediscover the Law of Gravity. Consequently, we could not be bullish any DGDF/RORO trades until we reach a new equilibrium, wherever that might prove to be. So we won't be going BOLIVIAN for a while.

So, will the Greeks reintroduce the drachma? They would be Cretans to stay in the Euro.....

[Can't believe nobody has used that one yet.]

Italy is really going to be under strain, not just economically but sociopolitically. If you have only been to orderly cities like Milan, you don't really understand Italy. You need to visit Naples, a visually beautiful city on the edge of anarchy and in constant chaos, and see the poverty of Calabria to really grasp what it is you are dealing with.

Anonymous said...

the UK appears like it will come out of the crisis wonderfully - monetization + getting the long term fiscal house in order?

if only those lessons were seen elsewhere

cpmppi said...

Thanks. Yes, they have certainly been "lucky" regarding the structural downward pressure on wages. And yes, we don't really expect wages to take off in this backdrop, but think this particular trade is quite an interesting option on things looking somewhat different.

cpmppi said...

Anon @ 3:26,
Expectations are certainly diminishing. But things would be somewhat worse had wages risen, offsetting competitiveness gains from the FX devaluation (as used to be the case with such moves). And while it is certainly painful for us all, rebalancing should be welcomed as setting the pace for sustainable growth in the years to come.

Looking at the economic situation in places that have not followed this policy path and it certainly makes TMM feel happy to be UK-based.

cpmppi said...

Anon @ 3:35,

Here, Here. We're looking at you Germany. Hoping to do more on that tomorrow...

cpmppi said...


Got just the T-Shirt for you:

Alen Mattich said...

Your argument's well made, but we're only part of the way into the process. I would argue that the BOE is trading future price stability for a little extra growth now.

The assumption seems to be that when the time comes, the BOE will be both able to identify when to remove stimulus and be willing to do so. My bet is that it'll be oblivious and reluctant and the U.K. will end up with another flavour of disaster.

Leftback said...

Very nice, cpmppi, I can see that is a source that TMM has mined repeatedly for inspiration in the past few months. But perhaps you own the company?

Alen, the BoE is far from helpless, since the UK have wisely retained the option of allowing the market to Bash Betty instead of submitting to the bond vigilantes.

I refer the Honorable Gentleman to the answer I have given previously, in regard to the curious case of the non-collapse of the JGBs, and to the oft-mentioned Widowmaker trade in that context....

Tradebot said...

TMM might be correct on the symptoms, but the causes of low wage growth in the UK has much more to do with UK opening up borders for the EU ascension countries. Add non-EU immigration and globalisation trends and hey presto , you got some serious pressure on wage growth. Merv the Swerve had little or nothing to do with this, if anything the QE has contributed to GBP weakness and follow through inflation via commodities.

However the decline of real incomes has introduced well needed competitiveness into UK economy, which in turn has kept the official unemployment under 10% / 3 mio. Note : UK does still have huge amount of workers on "incapacity benefit" , a rue designed to massage official numbers... but even with odd 500k of unemployed hidden there, you still end up with figures which compare favourably to continental europe (ex-Germany).

Oh, kudos about the short sterling trade , I like it and I been short the reds for few months now.

Alen Mattich said...

LB, I'm familiar with the Japanese widowmaker. One day that scythe will cut the other way.

But the thing about Japan (so far) is that it's had domestic buyers of the debt. The U.K. runs a capital account surplus. Once those crazy foreigners who are happy to take a two percentage point real loss on their capital realize they're being slaughtered by sterling as well, they may desist.

The thing about these extremes is when they snap back there's huge amounts of carnage. Remember, an unwillingness to accept slightly higher unemployment for a few years led to the Weimar catastrophe, the 1970s and the 2008 financial crisis. And the result has always been much higher levels of unemployment.

willem said...

"And while it is certainly painful for us all, rebalancing should be welcomed as setting the pace for sustainable growth in the years to come."

well said

Hotairmail said...

Keep your eye on trade credit insurance - it is going to gum up inter European trade. Being refused all over the place. Expect more pmi's like the German ones.

One of my big bugbears is that the ONS/BoE fail to fully measure the broader money supply. I would include credit derivatives (improved) but also trade credit terms (payment weeks etc.) and insurance (completely absent). It was a lack of credit terms that was a big part of the last financial crisis and statistically, it went almost entirely unrecorded.

Oh - love the blog by the way.

Leftback said...

Definitely not a Kevlar Gloves™ day over here. Gloves staying safely in the glove box.

EURUSD has room to roam to the downside now that Newtonian forces have re-established themselves on the currency pair. With no immediate sign of a US QE3 on the horizon and the prospect of a deep EZ recession OR massive ECB bond buying, you'd have to fancy 1.30 for EURUSD eventually, if not a fair bit lower.

A few rumbles over here about whether a few other smaller shops might have MF-type issues.

Anonymous said...

C says'
I told you I'd be waiting above ;)
and were I you thinking of falling knives I'd step aside. The sentiment and vix have birth more than adjusted for the summer extremes of bearish sentiment and frankly the degree of 'comfort' being displayed within the macro context is to me nothing less than foolish...we have people trying to squeeze what amounts to small upside rewards against a context that appears to offer far more downside risk.And it appears mainly that they do so because they think either BB ,or the Eurocrats will magically find a solution to macro problems.All i can say is they have more confidence in that than I do.

Polemic said...


abee crombie said...

I like the kevlar glove at when DVY gets to 200day, maybe tomorrow

buy the dips and sell the rips in this range bound market until mid december

abee crombie said...

sorry for the mass of comments today, but any thoughts on the Itilian repo markets. Some interesting stuff here, regarding the amount of repo fails. I am not sure how this all figures in, as its not my area. Any insight TMM

meph said...

If you put 44 catfood servings not 48 in a box, does that defy inflation expectations of the buyer? If we shop more often rather than more expensively, is the human mind that stupid? Can we cope with being poorer and poorer until we suddenly realise we buy catfood daily for 50 quid, and the wife spends a grand in Waitrose? Do we then eat the cat?

Top bungabunga-free post, top trade. Not sure on the timing, but you have to be in it to win it & downside looks limited.

Short cats as a hedge.

ntwsc said...

Well I fancy the multipack flavour exchange on the net idea, pretty sure TMM can allegorise this purrfectly.

Oh and my cat would better make a hat.

Tink said...

hello inflation just sucks,it was like a domino,connecting with each other.

--makati commercial rent

Anonymous said...

C says'

In reply to "kinell" which I'm not sure exactly what that means I didn't post yesterday to beat my own drum.In any case I need no reminder how quickly this market can turn around on newsflow.I posted just to make the point that there are really very few macro signposts pointing UP and there any many increasingly pointing down and the latter seem to be based upon where are we and where will be IF current policy maintains its' current heading.No more than that.

Anonymous said...

Could be risky ....................ah ha ha ha ha ha ha ha ha ha ha !!!!!!!!!!!!!