Blog

10-year Treasury yields have risen by 106 basis points (bp) from a low on 6 October and by 99 bp since a post on 5 November, drawing attention to a warning signal from the Korean bond market.

Yields could consolidate or correct lower following the recent surge; the Korean market has moved sideways since early November. Longer-term investors, however, should note that current levels continue to represent very poor value by historical standards.

The first chart shows 10-year yields, on a quarterly average basis, together with consensus 10-year consumer price inflation forecasts compiled by the Philadelphia Federal Reserve (i.e. from the Philadelphia Fed’s Survey of Professional Forecasters since 1991 and from either the Livingston Survey or Blue Chip Economic Indicators for earlier years). Consensus numbers are unavailable before 1979 but can be proxied by an exponentially-weighted moving average of actual inflation.

The second chart shows an estimate of real yields calculated by subtracting the consensus 10-year inflation forecasts (or proxy numbers before 1979) from the quarterly-average nominal yields.

In the first quarter of 2009 and the third quarter of 2010 real yields stood at just 0.3% and 0.5% respectively, well below previous post-war lows of 1.2% in the late 1950s and mid 1970s and 1.1% in 2003.

At the current level of about 3.5%, nominal yields are still only 1.3 percentage points above the consensus 10-year inflation forecast of 2.2%, as reported in the fourth-quarter Survey of Professional Forecasters. To return real yields to their median level of 2.7% since the early 1950s, nominal yields would have to rise to 4.9%, assuming no change in consensus inflation views. 

CPI inflation rose to an annual 3.3% in November and remains on course to reach 4% in early 2011, reflecting the impact of soaring commodity prices, the VAT hike and a stubborn “core” trend, which continues to defy Bank of England predictions of a slowdown in response to economic slack and fading exchange rate effects.

The November rise was driven by a pick-up in goods inflation from 2.6% to 2.9% as the food, alcohol and tobacco component moved up from 5.0% to 5.8% and non-energy industrial goods inflation firmed from 1.1% to 1.4%, mainly as a result of price hikes for clothing and household goods. Food inflation remains likely to reach 7% soon, as suggested in a post in September. Energy inflation fell from 4.0% to 3.5% but is heading significantly higher as recent rises in gas and electricity tariffs take effect. A further increase in overall goods inflation is also suggested by CBI industrial price expectations – see first chart.

Services inflation moderated from 3.8% to 3.7%, mainly reflecting a slowdown in transport services, but the VAT hike is likely to push it above 4% in the new year.

“Core” CPI inflation – excluding energy, food, alcohol and tobacco – was stable at 2.7% in November.

Key influences on the headline CPI rate over the next few months will be:

• Higher VAT pass-through than a year ago – estimated upward impact of up to 0.6 percentage points (pp). The Bank’s regional agents’ survey reports that most firms plan to pass on the hike in full.

• Announced increases in home energy tariffs – about 0.4 pp by next spring.

• Higher food commodity costs – 0.2 pp assuming annual food inflation reaches 7%.

• Higher vehicle fuel costs, with unleaded likely to rise above £1.25 per litre – little impact because of a similar increase a year ago but previously-expected downward effect no longer operative.

• Secondary food price effects via the “catering services” CPI component – 0.1 pp assuming annual inflation rises to about 4% from 3.3% currently (up from 3.0% in June).

• Accelerating housing rents – 0.1 pp assuming a rise in annual inflation from 1.5% in November to about 3%. Private-sector rents are growing strongly, according to the RICS letting agents’ survey – second chart.

High inflation threatens to slow the economic recovery by squeezing real incomes and money balances. By refusing to raise interest rates because of coming fiscal tightening, the Bank is encouraging high pass-through of cost-push pressures and a rise in inflationary expectations, thereby entrenching the current overshoot. Far from supporting the economy, its actions risk damaging medium-term growth prospects.

US employment figures for November were disappointing, showing a rise of only 50,000 in private-sector payrolls. Private job openings (i.e. vacancies), however, increased sharply in October, reaching a 26-month high, suggesting that employment growth will pick up in early 2011 – see first chart. (Openings are released a month later than payrolls but lead turning points in the latter by about six months.)

Job openings are rising at a similar pace to 2005, when private payrolls increased by nearly 200,000 a month. Assuming no change in government jobs, such growth would result in a steady decline in unemployment – payrolls need to rise by about 110,000 a month to keep the jobless rate stable, based on the recent rate of expansion of the working-age population and a constant labour-force participation rate.

In further evidence of improving US economic momentum, the six-month rate of change of the OECD’s US leading index stabilised in October while a “leading indicator of the leading index” strengthened for the third consecutive month – second chart. This improvement is occurring on schedule following an acceleration in US real narrow money since the summer, highlighted in numerous previous posts.

The view here remains that the Federal Reserve’s QE2 liquidity boost was unnecessary and is likely to prove counterproductive.

A year ago the consensus expected GDP to grow by 1.2% in 2010, according to the Treasury’s monthly survey of forecasters. The outturn is likely to be between 1.6% and 1.8% (depending on fourth-quarter performance and revisions). The latest Treasury survey shows an average projection for 2011 of 1.9% but this may again prove too low. Three alternative forecasting approaches, described below, all suggest growth of about 2.5%. A stronger performance is possible if global demand remains robust.
 
The first approach is a simple rule-of-thumb that classifies GDP prospects for the coming calendar year as strong, average or weak depending on whether December levels of real (i.e. inflation-adjusted) broad money growth and share prices are higher or lower than a year earlier. The two indicators gave a joint positive signal on 15 occasions between 1965 and 2008; GDP growth averaged 3.8% in the subsequent calendar year. A joint negative signal, meanwhile, occurred in 12 years and was followed, on average, by a GDP rise of only 0.3%. Such a negative reading was given in December 2008 before a 5.0% slump in GDP in 2009. Currently, real broad money growth is lower than in December 2009 while real share prices are higher. This combination occurred 11 times and was associated with average GDP growth of 2.5%.
 
The second approach uses a statistical forecasting model that projects annual GDP growth three quarters ahead based on current and lagged values of interest rates, real narrow and broad money supply growth, the effective exchange rate, the corporate liquidity ratio (i.e. companies’ bank deposits divided by bank borrowing), credit spreads and share prices. The current projection is for GDP to rise by 2.6% in the year to the third quarter of 2011, slightly down on the 2.8% gain in the year to the third quarter of 2010 (according to the latest official estimate). Assuming that the increase is spread evenly across quarters and growth continues at the same pace in the final quarter of 2011, the implied calendar year GDP rise is 2.8%.
 
A third approach is to base a forecast on the progression of GDP in previous recovery phases. The chart compares the fall and rebound in GDP from a high in the first quarter of 2008 with movements following cyclical peaks in the second quarter of 1973, second quarter of 1979 and second quarter of 1990. The recession and recovery to date bear the closest resemblance to the 1979-81 downturn and subsequent revival. The dashed blue line is a “projection” that assumes that the levels of GDP in the fourth quarters of 2011 and 2012 are the equivalent distance from the pre-recession peak as at the same points in the early 1980s recovery. This projection implies calendar year growth of 2.7% in 2011, rising to 3.5% in 2012. (Note that, in addition to the decline in GDP being larger in the early 1980s compared with the mid 1970s and early 1990s, growth was slower at this stage of the recovery. A forecast based on GDP progression in the 1970s or 1990s, therefore, would deliver a stronger number for 2011.)

The Federal Reserve’s QE2 securities purchases have started to lift the US monetary base (i.e. currency in circulation plus bank reserves) but it remains 8% below its February 2010 peak.

US stocks broadly tracked the monetary base between QE1 in late 2008 and this summer but broke to the upside when the Fed signalled QE2 – see first chart. They may need to tread water or correct over the next couple of months, although the base should eventually rise well beyond the level currently implied by the market if the Fed fulfills its intention of buying $600 billion by mid 2011 and fails to sterilise the impact on reserves (i.e. to about $2.5 trillion versus the current $1.98 trillion).

A comparison of the recent recovery in US stocks with an average of performance after six prior big bear markets, discussed in several previous posts, also suggests near-term consolidation – second chart. The market is exactly in line with the “six-bear average”, which meanders around the current level before another advance next spring.

US stocks traded above the six-bear average during the first year of the rally from March 2009 but have been mostly in line or below since G7 real narrow money growth fell beneath industrial output expansion in early 2010. As previously discussed, however, a positive “liquidity cross-over” could occur in early 2011. (Caveat: the range spanned by the historical recoveries widens as the distance from the 2009 low extends, suggesting that the average will become less useful for “anchoring” a forecast.)

Last week’s purchasing managers’ surveys for November were respectable but weighted-average G7 new orders failed to follow through on October’s strong gain – see first chart. The message is that industrial output expansion is reviving after a recent slowdown but should remain well below its pace in the first year of the recovery.

Country surveys show considerable divergence, with strength in China and the UK contrasting with notable weakness in Japan, partly reflecting this year’s surge in the yen – second chart. Chinese buoyancy, however, is no longer “good news” for the world economy and equity markets, since associated overheating pressures guarantee further significant policy tightening.

The small fall in the G7 new orders measure reflected slippage in the US component, which continues to follow the pattern of previous cycles – third chart. This comparison suggests further easing into early 2011, a prospect consistent with some slowdown in stockbuilding from its recent rapid pace.

As previously noted, G7 real narrow money continues to grow moderately, offering a reassuring message about the sustainability of the economic recovery, at least through mid 2011.

US monetary trends continue to strengthen, supporting hopes of faster economic growth in the first half of 2011.

The monetary pick-up is evident in both narrow and broad measures – see first chart – and began in the summer before QE2 was under serious discussion. By injecting further liquidity, the Fed may again be acting in a destabilising fashion, in a mirror-image of its withdrawal of liquidity in early 2010 when money supply trends were worryingly weak.

The current contrast between real M1 strength in the US and a sharp slowdown in the Eurozone is unusual, last occurring in 1991 – second chart. US equities outperformed continental Europe by 17% in 1991 and 13% in 1992, partly reflecting a stronger dollar. As of the end of November, US stocks are 15% ahead of continental Europe this year (MSCI indices).

Higher global crude oil costs, a fall in sterling against the US dollar and coming hikes in VAT and fuel duty suggest that the average price of unleaded petrol will rise from £1.191 a litre in November to more than £1.25 in early 2011, well above the May peak of £1.215. The average diesel price is already above its spring high.

Based on the spot market price, adjusted for current VAT and fuel duty rates, the retail unleaded price looks on course to rise to about £1.23 – see chart. The VAT increase and fuel duty hike of 0.76 pence a litre from January will add a further 3.3 pence, suggesting a retail price of about £1.26 barring a spot market slide.

Such an increase would not provide a further boost to annual CPI inflation because petrol prices rose similarly steeply a year ago. Forecasters’ previous assumption, however, that a slowdown in petrol inflation would partially offset upward pressures on the headline CPI rate is no valid. The view here remains that CPI inflation is likely to reach 4% or more early next year, a prospect endorsed by the MPC’s Andrew Sentance in a recent article.

In further evidence that Chinese inflationary pressure is spreading from food to “core”, output and input price balances in November’s purchasing managers surveys (official and private) reached new highs in their 5-6 year histories. Current readings suggest that producer price inflation will accelerate from an annual 5.0% in October to more than 10% in early 2011 – see chart. Faster PPI rises, in turn, should lift CPI ex. food inflation from 1.6% towards 3% – see previous post for a chart of this relationship. (Official CPI numbers, of course, understate on-the-ground inflation.)

Chinese policy-makers aim to quell inflation by clamping down on credit and money growth via hikes in reserve requirements and lower lending quotas, avoiding a big rise in interest rates. The strategy is flawed because any slowdown in monetary expansion is likely to be offset by a pick-up in the velocity of circulation as real interest rates fall deeper into negative territory, encouraging more spending and financial speculation. By delaying a significant rate hike, the authorities risk having to slam on the brakes in early 2011, with adverse implications for the economy later next year. 

Eurozone real narrow money, M1, has stagnated over the last six months, suggesting that economic growth will slow sharply in early 2011 – see previous post.

M1 comprises currency in circulation and overnight deposits. The first chart shows the six-month change in real overnight deposits broken between the “core” and “periphery” (currency figures are not available by country).

The pace of contraction in the peripheral group eased in October but still signals economic stagnation, at best, in early 2011. The further fall in Eurozone-wide growth last month reflected a loss of momentum in the core, casting doubt on the ability of these economies to continue to decouple from peripheral weakness.

The second and third charts show a country breakdown. Real M1 deposits have contracted over the last six months in all five peripheral economies and also in Belgium and the Netherlands.

The ECB may have contributed to this weakness: its decision to withdraw 12- and six-month lending facilities has resulted in a 20% fall in the monetary base since June, in turn pushing up EONIA and increasing funding pressures on struggling banks. A reinjection of liquidity is urgently required but policy-makers are reluctant to reopen the lending window for fear of being swamped by demand from weaker sovereigns seeking back-door support via local banks.