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The Kondratyev cycle is a 54-year fluctuation in wholesale prices comprising 27-year upswing and downswing phases.

The cycle is global in nature but can be tracked conveniently using UK WPI information, which extends back to the 18th century – see first chart. The cycle is evident in price levels until the second world war and inflation rates thereafter (reflecting the 1930s demise of the gold standard).

The last cycle peak in 1974 was followed by a 27-year downswing to a trough in 2001. WPI inflation is now a decade into another 27-year upswing that is scheduled to peak in 2028.

The second chart explores the relationship between the Kondratyev cycle and US Treasury yields. Yields peaked in 1981, seven years after the inflation peak, and retested their high two years later. The secular bond bull market began in earnest in 1984, nine years after the Kondratyev peak.

This lag may reflect the behaviour of monetary policy-makers, who took a long time to be convinced that the trend in inflation had reversed and they could afford to loosen.

Recent developments are the mirror-image of the 1970s / 1980s. Consistent with the timing at the peak, the Kondratyev cycle trough of 2001 was followed by a low in Treasury yields seven years later in 2008. This low was retested and rejected last year, nine years after the inflation trough.

The suggestion, therefore, is that the interest-rate cycle is in a similar position to 1984 but with yields now about to embark on a sustained rise. The trigger for such a trend change could be a hawkish shift in monetary policies during 2011, led by emerging economies, as the well-advanced upswing in WPI inflation extends and broadens out to consumer prices.

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COMMENT:
AUTHOR: Gary_UK
EMAIL: superfurry7@gmail.com
IP: 91.104.217.241
URL:
DATE: 01/18/2011 09:08:07 PM

Interesting article.

Another view is that the deflationary collapse will be hastened by the current 'bubble' price increases in commodities caused mainly by QE in the US.
Bernanke et al simply can't afford for rates to rise, so another deflationary episode to prolong the pretence is just around the corner.

With the December rise to 3.7%, CPI inflation averaged 3.4% in the fourth quarter, representing another significant overshoot of the Bank of England’s central forecasts of 3.2% in the November Inflation Report and 3.0% in August.
 
The 3.7% print was above a median forecast of 3.4%, according to Bloomberg, but in line with a projected profile for CPI inflation presented in a post last week. Inflation is now certain to move above 4% in early 2011, a prospect belatedly recognised by the consensus. Assuming no further rise in global commodity prices, the headline rate may reach 4.3% in February, remaining at or above 4% until late 2011.
 
While food and energy prices were the key upward driver in December, the Bank’s forecasting miss also reflects stubborn core inflation, which continues to defy its prediction of a slowdown in response to economic slack and fading exchange rate effects. CPI inflation excluding energy, food, alcohol and tobacco firmed to 2.9%, a six-month high.
 
It has recently become fashionable to quote the tax-adjusted inflation measures, CPI-CT and CPIY, which are running well below headline inflation, at 1.9% and 2.0% respectively (up from 1.5% and 1.6% in November). CPI-CT is calculated at constant tax rates while CPIY excludes indirect taxes altogether.
 
These measures, however, understate “true” inflation because they are calculated on the assumption that indirect tax hikes are passed on in full to consumers. ONS research on the December 2008 VAT reduction from 17.5% to 15% indicated pass-through of only one-third. Assuming that one-half of the increase in VAT and other indirect taxes last year was reflected in the prices charged to consumers, inflation would now be about 2.8% had tax rates remained stable.
 
The current inflation overshoot should be viewed in a longer-term context. The consumer prices index for December was 4.4 percentage points above the level implied if the Bank of England had achieved 2% inflation since the target was switched to the CPI in December 2003, implying an average overshoot of 0.6% per annum. The RPIX measure (i.e. retail prices excluding mortgage interest costs) has exceeded the previous 2.5% inflation target by 5.3 percentage points over this period.
 
Advocates of a rise in interest rates are not “inflation nutters” but believe action is required to prevent an upward drift in inflationary expectations that would worsen the output-inflation trade-off, thereby depressing medium-term growth prospects.

In May 2009, the Bank of England forecast that CPI inflation, then 2.9%, would fall to 0.7% in the second quarter of 2010. The outturn was 3.5%. In the August 2010 Inflation Report, the Bank presented an analysis of this forecasting “miss”. It concluded that one-third of the error reflected higher-than-expected energy prices, with the remainder due to a combination of underestimation of upward pressure from sterling weakness and rising VAT and overestimation of the disinflationary impact of the negative “output gap”.

To make one huge forecasting mistake may be regarded as a misfortune; a repeat performance this year would seriously damage the Bank’s credibility. Such an outcome, unfortunately, is probable. The same August Inflation Report forecast that CPI inflation would fall to 2.8% in the second quarter of 2011 on the way to 2.2% by the fourth quarter. Based on recent trends, these numbers may be overshot by 1.0-1.5 percentage points – the chart shows a possible profile.

What has gone wrong this time? The Bank cannot blame the latest VAT rise, the impact of which was supposedly incorporated into the August forecast. It will no doubt attribute a significant portion of the overshoot to higher commodity prices but were these really unpredictable? Commodity costs have been positively correlated with emerging-world growth in recent years and the latter was widely expected to remain strong. The Bank’s default assumption of stable prices (or evolution as implied by futures markets) represents a dereliction of analysis.

Three more fundamental criticisms, however, can be made. First, the Bank, in time-honoured fashion, has misread monetary developments. Most MPC members pay little attention to the monetary side of the economy but those who do, including Governor King, have wrongly concluded that slow broad money growth precludes sustained high inflation. As argued in previous posts, however, this ignores the negative impact on the demand to hold money of the negative real interest rates imposed by the Bank. Weaker money demand has resulted in an inflationary monetary excess despite low supply expansion. (This argument has been ignored in the recent exchanges between Sunday Telegraph columnist Liam Halligan and leading monetarist Professor Tim Congdon about the inflationary impact of the Bank’s policies.)

Secondly, the Bank has continued to place unwise reliance on “output gapology” despite well-known difficulties in measuring economic slack and uncertainty about its disinflationary impact. A post in January last year presented evidence suggesting that GDP was then only about 2% below its trend or potential level versus an OECD estimate of a 7% gap – probably representative of the Bank’s thinking at the time. The sensitivity of inflation to the domestic gap, meanwhile, may have fallen significantly since the last recession in the early 1990s, reflecting the globalisation of the economy.

Thirdly, the Bank has underestimated the impact on expectations of the inflation overshoot and its own failure to react. Judging by survey evidence, firms and retailers plan to pass on the bulk of recent cost increases and the VAT hike to buyers, suggesting confidence that the MPC will continue to accommodate above-target inflation. The Citigroup / YouGov measure of household longer-term inflation expectations (i.e. over the next five to 10 years), meanwhile, has surged to 3.8%, a level exceeded in only two months since the survey’s inception in 2005. This pick-up appears to be feeding through to pay settlements, with private deals moving up towards 3%, according to research firm Incomes Data Services.

Current inflation difficulties would be less severe had the Bank raised interest rates in mid-2010, as suggested here; this would have boosted the exchange rate, thereby restraining import cost increases, while bolstering the MPC’s inflation-fighting credibility and firing a warning shot across the bows of firms planning price hikes. With the relationship between banks’ funding costs and Bank rate much weaker than in the past, such an increase would probably have had limited impact on lending rates. The net effect, indeed, may have been to support economic growth by moderating the inflation squeeze on real income and money supply expansion.

The MPC’s Andrew Sentance, who has voted for higher rates since June, is winning the argument and deserves greater support from his colleagues. The December minutes revealed a small shift towards increased inflation concern and the “MPC-ometer” model suggests that this will continue at this week’s meeting, with a possibility of another member supporting a hike. Poor economic news (fourth-quarter GDP growth is released on 25 January) or a set-back in markets could intervene but Dr. Sentance may yet achieve his aim of moving rates higher before his second MPC term expires at the end of May.


The OECD’s leading indicator indices for November signal a short-term upswing in global industrial momentum, validating a forecast made last July on the basis of monetary developments. The improvement, however, does not extend to the beleaguered EMU-periphery.

The chart shows six-month changes in combined industrial output and a leading index for the group (i.e. Italy, Spain, Portugal, Greece and Ireland) together with a “leading indicator of the leading index”, which heralds turning points. The six-month decline in the index accelerated further in November and the double-lead indicator has yet to signal a bottom.

This weakness is consistent with an ongoing contraction of real narrow money discussed in a previous post.

These developments suggest that the recent fall in EMU-periphery industrial output will gather pace in early 2011. Economic weakness is likely to undermine fiscal consolidation plans, in turn ensuring that the sovereign debt crisis rumbles on.

UK institutions’ money holdings are at their lowest level since 2006, implying less fire-power to buy gilts and other assets.

Insurance companies’ and pension funds’ holdings of bank deposits and short-term money market instruments stood at £140 billion in September 2010, down from a peak of £180 billion in September 2008 and the lowest since June 2006, according to the Office for National Statistics.

The liquidity ratio (i.e. money holdings as a percentage of the value of financial investments) was 5.6% in September, down from an 18-year high of 8.6% in September 2008 and the lowest since March 2002 – see chart.

Institutions generally target a stable proportion of money in portfolios over the medium term, increasing investment in markets when the liquidity ratio is high and vice versa. Historically, the level of the ratio has been positively correlated with subsequent real equity market returns, as discussed in a post in early 2009.

At 5.6%, the liquidity ratio is below its average of 6.4% since 1987. Institutions have been directing the bulk of new investment into gilts recently, buying £15 billion in the year to September. Weaker institutional demand could add to upward pressure on gilt yields from a slowdown in overseas buying – see post last week.

QE2 euphoria resulted in stocks, commodities and other “risk” assets performing strongly last quarter. However, our key indicator of global liquidity availability – the annual growth rate gap between G7 real narrow money and industrial output – remains negative, suggesting a cautious investment stance in early 2011.

The world economy expanded robustly in 2010, with the IMF’s GDP measure rising by an estimated 4.8% – far above predictions of about 3% at the start of the year. Growth is likely to moderate in 2011 but rising inflation may force more widespread monetary policy tightening. Markets may struggle against this backdrop as the Fed’s QE2 stimulus runs out.

Our liquidity indicator had given a “buy” signal for equities in late 2008 but turned negative in early 2010 as slowing G7 real money growth fell beneath surging output expansion. Equities subsequently corrected sharply and the EAFE index in US dollar terms was still down from its end-2009 level at the start of October. Markets reversed, however, as the Fed signalled a new QE initiative, following through with an announcement in November of a further net $600 billion of securities purchases to be completed by mid-2011.

On the latest full data, for October 2010, G7 real narrow money was up by 4% from a year earlier versus a 6% gain in industrial output. The gap has been narrowing as output expansion moderates and a positive cross-over is possible soon, assuming stable real money growth. The latter, however, could also fall as inflation picks up. Caution is warranted until a “buy” signal is confirmed – equities, historically, have sometimes weakened sharply in the final months of a negative liquidity environment.

A further reason for questioning the current bullish consensus is the historical pattern of recoveries after large bear markets. The Dow Industrials index fell by about 50% on six occasions during the last century. The nearby chart compares an average of the subsequent recoveries with the rally from the March 2009 trough, which followed a 54% decline. The “six-bear average” has proved a reasonable guide to recent performance and suggests that equities are entering a flat to weaker phase.

A key supportive factor for equities this year should be a further pick-up in M&A activity, which reached a nine-quarter high in dollar volume terms last quarter, according to Bloomberg. Corporate liquidity is plentiful and confidence is returning, as reflected in strengthening capital spending and recent signs of firming labour demand. Bank credit supply, however, could constrain large cash-financed deals.

GDP growth exceeded expectations in most developed and emerging economies last year but greater variation is likely in 2011. Monetary trends suggest solid US prospects (money growth was accelerating before QE2) but a sharp slowdown in the Eurozone, as the southern periphery stagnates. The emerging world is buoyant currently but overheating pressures and associated further monetary policy tightening promise a shift towards weakness later in the year.

Our regional / country allocation is informed by relative money supply growth, which was strong in Canada and the US and very weak in the EMU-periphery at the start of last quarter. The Canadian and US markets outperformed in common currency terms over the three months, though were beaten by Japan, while the Eurozone lagged badly.

Recent real narrow money trends are shown in the second accompanying chart. The US has improved further but Canada has fallen back to the middle of the ranking, with money growth now stronger in Australia. Other markets scoring well include Sweden and Switzerland. Monetary trends, meanwhile, have weakened further in Euroland while giving a neutral message in Japan and the UK.

The monetary pick-up in Australia suggests that this market is a potential “buy” but some caution is warranted given the strength of the currency, which has been boosted by recent commodity price gains and could correct if these subside as QE2 stimulus fades and emerging economies slow later in 2011.

While UK monetary trends are lacklustre, the market could benefit disproportionately from a further increase in global M&A while retail interest in equities is reviving. Discouragingly, however, UK institutions continued to sell domestic equities in the third quarter, a trend that may continue given a recent fall in their cash holdings.

Eurozone equities look cheap relative to other markets following last year’s underperformance: the price to book of the region relative to the World index is at its lowest since 1996. With money supply weakness spreading from the periphery to core economies, however, and the ECB constrained by philosophy and above-target inflation from pursuing Fed-style QE, a reversal may be delayed.

The outperformance of the Japanese market last quarter reflected, as usual, foreign buying, which could continue in early 2011 as economic news improves. Monetary trends are unexciting but Japan is at no risk of inflation and policy settings will remain loose – a potential attraction in a year when many other countries could tighten.

Real narrow money growth remains generally strong in emerging economies but this may now be a hindrance rather than help to equities because of the implications for inflation and further policy restriction. With emerging markets, unusually, trading at a price to book premium to developed markets, and worries growing about a Chinese “hard landing”, the consensus expectation of continued outperformance is questionable.


The recent sell-off in gilts would have been more severe but for heavy buying by banks and building societies, according to November monetary statistics released today.

Banks and building societies bought £10.0 billion of gilts in November, the largest amount since January 2009. The purchases offset sales of £5.7 billion by domestic non-bank investors, while overseas buying slowed to £3.3 billion, the smallest since June.

Despite the November fall, overseas investors have absorbed £50.6 billion of net gilt issuance of £107.8 billion in the first eight months of 2010-11, or 47%. With foreign demand probably now waning, further strong banking-sector buying is likely to be needed to avert a rise in gilt yields.

Large-scale November purchases may have partly reflected banks’ surprise that the MPC failed to copy the Federal Reserve by launching QE2 that month. This would have boosted their cash reserves at the Bank of England, allowing them to meet their objective of raising liquid asset holdings without buying more gilts.

Monetary news within today’s release was mixed, suggesting a slowdown in economic growth during the first half of 2011. The Bank’s preferred broad money aggregate, M4ex, rose at a faster 3.5% annualised rate in the three months to November but has been boosted by a probably-temporary rise in securities dealers’ deposits. Money holdings of private non-financial corporations fell over the latest three months, reducing annual growth to 2.6% from 5.1% in September. Narrow money, M1, also contracted, echoing weakness in the Eurozone.

A key concern is the squeeze on real money supply trends from rising inflation, with the CPI headline rate on course to exceed 4% in early 2011. The demand to hold money may simultaneously decline as real deposit interest rates fall deeper into negative territory but the net effect may be to constrain the economic recovery.

The inflation squeeze would be less intense had the MPC raised rates last summer; this would have boosted sterling, restraining import cost increases, while firing a shot across the bows of firms planning price hikes. Policy tightening is now urgently required; medium-term growth prospects will be much worse if the current inflation overshoot becomes entrenched.

Eurozone narrow money trends continue to weaken, signalling a sharp slowdown in economic growth in the first half of 2011.

Commentary on November monetary statistics is likely to focus on a small pick-up in broad money, M3, growth, to an annual 1.9% from 0.9% in October. Narrow money, M1, however, has been a much better economic leading indicator historically; it contracted in real terms ahead of the last recession, while M3 was still growing solidly. M1 rose by an annual 4.6% in November, down from 4.9% in October. Ominously, its inflation-adjusted level was lower than six months earlier – see first chart.

M1 comprises currency in circulation and overnight deposits – forms of money more likely to be related to economic transactions. M3 also includes time and notice deposits and money market funds, making it more susceptible to changes in savings behaviour. The recent slight pick-up reflects these components and is probably related to escalating financial stress that has caused investors to hold more of their wealth in liquid form (i.e. a rise in the precautionary demand for money).

Available country M1 information suggests that the Eurozone periphery is locked into a “double dip” that will undermine fiscal consolidation plans. The ECB publishes a country breakdown of overnight deposits but not currency. The deposits analysis shows a 2.8% real contraction (not annualised) in peripheral economies – Greece, Ireland, Italy, Portugal and Spain – over the last six months. This is comparable with the decline in early 2008 just ahead of the plunge into recession – second chart. Weakness is most pronounced in Greece but real M1 deposits are falling in all five economies, with a notable acceleration in the pace of contraction in Italy recently – third chart.

Eurozone-wide real M1 trends are stronger than in early 2008, reflecting continued expansion in the core – Austria, Benelux, France and Germany. Core growth, however, has fallen sharply since the summer, suggesting a slowdown in internal economic momentum to accompany an intensifying drag from the periphery. Country figures reveal a contraction of real M1 deposits in Belgium and the smallest six-month rise in Germany since late 2008.

Revised GDP figures continue to portray a solid economic recovery, with nominal demand growing above a rate likely to be compatible with the inflation target over the medium term.

• GDP grew by 2.7% in the year to the third quarter, revised down from 2.8%. Assuming, conservatively, a quarterly gain of 0.5% in the current quarter, full-year growth will be 1.7% versus a consensus forecast of 1.3% in December 2009.

• The official GDP series relies on output data; an expenditure-based estimate rose by 2.9% in the year to the third quarter (i.e. adding back the “statistical discrepancy”).

• Encouragingly, annual growth in business investment was revised up substantially, from 4.6% to 8.9%, showing that spending is responding as expected to an earlier strong improvement in corporate liquidity – see first chart. Also, the household saving ratio rebounded from 3.5% to 5.0% in the third quarter, implying that consumers have more in reserve as high inflation and tax hikes constrain real income expansion. Stockbuilding, meanwhile, was modest last quarter, at 0.1% of GDP.

• Discouragingly, the previously-reported improvement in net exports in the third quarter has been revised away, dashing the MPC’s hopes that “the necessary rebalancing towards net trade might have begun” (according to the December minutes).

• The annual increase in the GDP deflator at market prices was revised down from 3.0% to 2.4%, accounting for the bulk of a reduction in nominal GDP expansion from 5.9% to 5.1%. The latter figure, however, was depressed by a large rise in the trade deficit between the third quarters of 2009 and 2010, partly reflecting surging import costs. A more appropriate focus for the MPC is nominal domestic demand, which rose by an annual 6.8% (revised from 7.1%) – the fastest since 1999.

• Relative to the pre-recession peak, GDP is slightly ahead of the level at the corresponding stage of the early 1980s recovery, which followed a recession of comparable scale (slightly deeper if measured by GDP excluding North Sea oil and gas production) – second chart.

One of the many unfair criticisms of British banks is that they have failed to “pass on” official interest rate cuts, using wider margins to boost profits. Such claims are “supported” by reference to unusually-large spreads between lending rates and Bank rate – the average interest rate on the outstanding stock of bank and building society mortgages, for example, is currently 3.0 percentage points above the 0.5% Bank rate versus an average of 0.6 points over 2005-07, before the financial crisis.

Such statistics, however, are bogus because banks are unable to obtain marginal funding at Bank rate, or even at quoted short-term interbank rates in any size. A better guide to their cost of borrowing is the average interest rate on household time deposits – currently 2.6%. The spread of the average mortgage rate of 3.5% over the time deposit rate is 0.9 percentage points, below the 1.1 point average over 2005-07 – see chart.

Net interest income, in fact, suffers rather than benefits from low official rates, partly because banks are net lenders of funds at Bank rate as a result of QE – their cash reserves at the Bank of England now stand at £140 billion, or 3.7% of their sterling assets, versus about £20 billion before the crisis. The Bank, rather than commercial banks, is enjoying a major boost to its net income, with reserve liabilities earning Bank rate used to finance a gilt portfolio with an average running yield of about 4%.

The disconnect between Bank rate and banks’ funding costs undermines another common claim – that lending rates would fully reflect any rise in official rates, resulting in a squeeze on borrowers’ incomes that could abort the economic recovery. With the time deposit rate so far above Bank rate, it is much more likely that this spread – rather than lending rates – would take the strain in the initial stages of any policy tightening.

An increase in Bank rate, in other words, would help to bolster the Bank’s inflation-fighting credentials and cap inflationary expectations without material damage to economic prospects.