Long-Term Government bonds surge and UK inflation disappoints again remaining above 3%

We saw stock markets at least in Europe and America have a dull somewhat listless day yesterday. However as I shall discuss later government bond markets apart from some of the peripheral markets surged from what were already high levels. If we take a look at commodity prices then the Commodity Research Board’s spot index rallied to 448.71 which was up 1.23. The two main components of this which rose were Fats and Oils, and Livestock both of which rose by more than 2%. However the excitement surrounding the price of wheat has calmed down as the price has now drifted back to just over US $7 per bushel.

If we look at currencies then current levels remind me of the pressures of the carry trade. Both currencies which were associated with this are quite strong again. I wrote about the Japanese Yen yesterday and some of its effects and at 109.64 versus the Euro and 85.28 versus the US dollar it remains strong. However I am reminded today of the strength of the Swiss Franc which is at 1.3356 versus the Euro and am also reminded of all the holders of Swiss Franc denominated mortgage and other debt in Eastern Europe who probably check this exchange rate every day. I discussed the (serious) issues at hand here on the 19th of July for Hungary and the 10th of June for Switzerland.

World Government Bond markets surge

This has been a subject which has been a recurring theme in recent days and weeks as many of the worlds main government bond markets have been rallying. This has occurred at a time when in general they are facing high levels of fiscal deficits and hence high prospective borrowing levels but the rally has shrugged this inconvenient fact off as if it is a lightweight. The apparent slowdown in the US economy followed by the intervention of the US Federal Reserve with what has been titled QE 1.1 last week has led to prices going higher and higher whilst yields go lower and lower.

This move certainly continued yesterday where it was most marked at the longer end of the maturity spectrum. For example the thirty-year US Treasury Bond yield fell to 3.71%, there is a 50 year UK gilt and its yield touched 4%, the German 30 year bund yield fell to just below 3.1%. I have got used to reporting lower ten-year yields and they are falling too with the US version at 2.6%, the German bund at 2.36% and the UK gilt falling to 3.05% but the latest surge if I may put it like that is happening at the longer end of the maturity spectrum.

Comment

If you think about it this latest move is in some ways the most significant. The reason for this is the time to maturity of these bonds. If we think of the longest one here the UK gilt and analyse it then one is left with a 2 and a half point rally reducing its yield by around 0.1%. Then please think that this 0.1% is a lower yield for each of the next 50 years I hope my point becomes clearer. Such a move if you assume it is rational implies a downgrading of our economic prospects for the next 50 years. Now to my mind there are many alternatives for the UK economy over the next few years let alone the next 50! In principle this is true for the German or US equivalents except their timescale is 30 years. There is a subtle but quite powerful downgrading of economic prospects in this move. If I may look at the UK again in detail and think of our economic history over the time I have been following it then a yield of 4% over 50 years looks discernably unattractive to me. Our ten-year yield of 3.05% is intriguingly below the inflation rate just announced of 3.1% and that is for the official CPI as Retail Price Inflation is much higher. There is much food for thought in these facts.

The Peripheral Countries in the Euro zone

Whilst many government bond markets are rallying we are seeing a different effect in the periphery of the euro zone. I updated my views on Greece’s economic prospects on Friday and her ten-year government bond yield rose yesterday by nearly a quarter of a percentage point to 10.87% which contrasts wildly with the yields discussed above. Ireland has a ten-year government bond yield of 5.41% whilst Portugal’s is 5.38% and Spain’s is 4.25%. Whilst these are only edging higher in absolute terms in relative terms we are starting to see something of a swing again as other government bond yields are falling.

On this subject the spread between ten-year German bunds and their Irish equivalent has been widening in recent days. One factor in this is the continued disappointing performance of the nationalised lender Anglo-Irish Bank where matters only ever seem to get worse. Also some of the Irish governments support schemes for her banking sector are due to end in 2010 and there is concern and debate over the implications of this. There are debt auctions today and the results will be interesting. Ireland is trying hard to escape her problems but the collapse of her property market and much of the lending that surrounded its boom is continuing to act like a dragging anchor on her.

UK Inflation for July 2010

Consumer Price Index inflation in the UK fell back slightly to 3.1% on an annualised basis in July which compares with 3.2% in June. The factors at play were varied as you might expect in such a small move. The downward influences were fuel prices, transport costs,clothing and footwear and recreation and culture. The slightly weaker upward influences were food and non-alcoholic beverages and furniture and household equipment. Female readers may be pleased to see that the fall in clothing and footwear prices appears to have been mainly concentrated in women’s outerwear and footwear.

Retail Price Index inflation fell by slightly more to 4.8%  in July which compares with 5% in June. The main factors which affected CPI are at play here and in addition there was a fall in insurance prices have a higher weighting in the RPI than CPI. Our previous measure for an inflation target RPIX also fell from 5% to 4.8%.There is a subliminal effort by the ONS to downgrade the importance of RPI in people’s minds in its Statistical Bulletin by the way you have to read down to page 6 now to see a mention of the Retail Price Index at all.

Comment

Whilst inflation has declined slightly this month and is welcome this is not to my mind on anything like the scale that was intended or meant by the Monetary Policy Committee back at the beginning of this year when they said that inflation rises would be temporary. It has gone higher and lasted longer than they thought. Whilst the ONS has joined in the official consensus as I have discussed above to get everybody to concentrate on the lower CPI figures the fact remains that they are bad enough. If we look at our previous targeted inflation measure of RPIX it is at 4.8% which is some 2.3% above its target of 2.5%.

So it would appear that the institutional pressure to get everyone to accept CPI as the premier inflation measure is increasing. This appears to be something of a cross-party consensus as it was Gordon Brown of the Labour party who introduced it and a coalition between the Conservatives and Liberal Democrats who are currently trying to increase its influence. The fact that it produces generally lower inflation figures than its predecessor appears to be the main driving force behind this and this rather transparent effort can only reduce the already damaged credibility of inflation targeting in the UK.

The Governor of the Bank of England has now had to write his eighth letter to the Chancellor of the Exchequer to explain why inflation is more than one per cent away from its targeted level. All eight are to explain divergences on the upside which when you consider that we have been through an extraordinary downside shock to the UK economy involving a fall in economic output of approximately 6 per cent in a year gives plenty of food for thought.Exactly what would create a downside divergence under the policy of the MPC? Actually if you look at the biases in their policy actions I hope that we do not find out because it would come with some very unpleasant implications.

Mervyn King’s Letter to the Chancellor

This was published this morning and in it was an improvement I feel as we saw a little honesty which I would like to see more of.

And the recent strength of inflation has surprised the MPC.

Unfortunately it is accompanied by the same old mantra of output gap theory and talk of the upward inflationary effects being temporary. My problem with output gap theory is that its proponents on the MPC keep reciting it when the actual evidence does not show it. For example if we look at the latest figures published today there were two-way price movements whereas under output gap theory they should be pretty much one way and in fact if we ignore the VAT change should have been one-way for quite some time.Keynes quote of “when the facts change I change my mind” seems appropriate here to me.

With the US and Japanese economy appearing to slowdown we are going into a potentially difficult period for the UK economy so for once I am in agreement with a wait and see approach except for one catch. We remain in my view with the error made by the MPC at the turn of the year when it had a chance to respond to likely inflation increases and did not take it.

The two strands of my article today inflation and goverment bonds come together here for the UK. Pretty much whatever your view on UK inflation it is hard to avoid the view that we appear to remain more prone to inflation than many others. It is somewhat symbolic that even our downgraded measure of inflation CPI has a higher reading than the yield level on a ten-year gilt. The old measure RPIX is much higher. Now whilst there will be many other months in the ten year life of a government bond it does pose the thought that logically they must be expecting quite an improvement which is at odds with an MPC to whom inflation surprises appear to be consistently upwards.

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15 thoughts on “Long-Term Government bonds surge and UK inflation disappoints again remaining above 3%

  1. Why is the UK so much more prone to price increases than equivalent sized economies?
    I think one reason at the moment is that SMEs are using cashflow rather than loans and are keeping prices high. But this can only be part of the story. Do you think the UK is a 90/10 economy, ie 90 of the pricing power in just about every area is dominated by 10% of the organisations? Compare that with European equivalents, even Italy where the economy is far more dominated by smaller companies.
    The Uk sometimes prides itself with its open, competitive ‘anglo-saxon’ economy, is it really delusional, isn’t there are a far greater concentration of power in the UK than many countries? And isn’t this the real reason for price ‘stickiness’?

  2. Hi Shaun,

    Glad to see the blog comments section is lively again, it went through a quiet patch a few weeks ago.

    Could the US especially, but even the UK, renew their debts early to take advantage of these, in real terms, zero rates?

    As you have pointed out the total debt of country does not take into account when the debt has to be serviced which can be a more enlightening detail. Does a measure of government debt exist which includes discounted rates, at these rates the debt for the US is not quite as nasty as it sounds?

    In the Uk at least the deficit reduction arguments seem to have gone quiet, surely now would be the time time for Kenyesians to make their noise.

    • Hi Fletch
      I imagined many people were on holiday but it didnt take long to pick up again. As to debt management then yes if I was in charge I would be looking to do that. Frankly if you were issuing debt on behalf of the UK or US now is a good time in my opinion because of the low yield levels which you would be locking into for the maturity of the bond. The US & UK do publish timetables so there are limits as to what you could do in the very short term but there is no reason why you cannot raise the amounts at the next issuance date. To its credit the UK Debt Management Agency has been doing some of this the last time I looked at the numbers. As prices rise and yields continue to fall it may look tactically unwise for a while but strategically it is likely to give rewards.

      I think I get what you mean about discounted rates as in what interest rate in effect takes her size of debt problem away. The trouble is this is quite complicated because of the variables involved and because some rates are variable such as on their equivalent of index-linked stock called TIPS. So not really sorry. As for this year the low interest rates on issuance have been a boon for this years deficit and no doubt Mr.Geithner is pleased by this.

  3. I think a 2% inflation target is a luxury for Britain. As far as I understand, this was meant to be an optimal target because it was thought to be the most efficient for the economy of the country at the time of its conception.

    Now the situation is very different, the real challenge facing Britain is not one of ‘efficiency’ it’s overwhelming debt (and badly allocated resources). So the choices faced are then:
    1) Amazing productivity growth — unlikely, and possibly dangerous (in terms of social consequences)
    2) (Partial) Default, ie. moderate/high sustained inflation
    3) Isolationism, ie. stop global trade — bad for the world bad for the country in the long term.
    4) World war — horrible, as the one after that would be fought with sticks instead of nuclear weapons…

    Which option looks most attractive?

    In the 1990s crisis many of the developing countries defaulted. UK is a democracy, its main responsibility is to its citizens, a 2% inflation target is unrealistic and _economically_ not sensible.

    • Hi Burak, I believe the target of 2 % inflation is essentially chosen because any level of inflation above 2 % causes undesirable economic problems. It has been reasoned by economists that in the Keynesian manner 2 % inflation provides just the optimal stimulus to growth to ensure that it continues. Any higher level causes adverse effects.

      Thus it is not valid to suggest that in the present situation a higher level of inflation will not cause the same effects. Inflation always causes the same effects. Two of the worst ones are that the cost of the same real level of government spending rises, and the capital operating base of enterprises is eroded forcing them into a position where they are over-trading and facing probable insolvency unless they can replenish their capital base to support the same level of trading; (this is extremely difficult for them to do in a recession). Higher inflation will exacerbate these effects, causing more enterprises to become insolvent and thus jobs to be lost. Then there is the inevitable consequence of stagflation which results mainly due to trade unions then understandably demanding increases in pay to offset the net inflation position (i.e. after tax).

      Inflation is thus the quick fix for governments which cannot control their spending, but like most quick fixes there are resultant dire consequences.

      I do not comprehend how you can imagine that inflation could under any circumstances lead to “amazing productivity growth”. I would dispute that as being entirely falacious.

      Against all the dire consequences which result from any higher level of inflation than 2 % I would argue that 2 % is as much as should be permitted with fiat currencies whatever the economic conditions; otherwise the price must and will be paid. It must be remembered that even with 2 % inflation it is the government which pockets the 2 % each year, with fiat currencies, as an additional insidious form of stealth taxation.

      • Drf, where is the empirical evidence that 2% is better or worse than any other number taken at random. Economics say a lot, most of it is wrong. Surely any number greater than Zero is a ‘tax’ by your argument.
        If CPIY is below 2% and dropping and wages and velocity of money is stagnant, where is the inflation? There are price increases from external, uncontrollable sources and there are taxes, so interest rates should increase because of these? The logic of ‘common sense’ says this would be plainly daft.

      • Hi Drf,

        Those options I listed are meant to be mutually exclusive, so I’m not suggesting inflation would cause productivity growth. Looking at the example of Japan as the future of Europe, the productivity growth is likely to stall anyway.

        So essentially, short of closing the borders the only pragmatic solution is a default of some kind for many highly indebted countries, not the least Greece. What kind of default, is another choice obviously, inflation being a so-called stealth default here.

        As for inflation being a tax, as far as I understand, inflation transfers (arbitrarily) wealth from the creditor the debtor, not just to the government. And remember that individuals as well as corporations are highly indebted in Britain. This arbitrary transfer is one of the biggest reasons why it’d be unethical to cause high inflation. Yet, (not owning a penny to anyone), I’d still argue inflation as a way to go for the West.

        I understand your point with 2% being perceived as the most efficient in normal situations for the economy, but I’m afraid that’s too late. An (perhaps imperfect) analogy to this would be prescribing a post-stroke patient 6 day heavy sports a week. That may be the healthiest for a young person, but this patient needs to lose a lot of weight first…

      • Hi JW; I do not believe that there is any empirical evidence, which has been obtained under properly controlled statistical conditions, to show that 2 % or any other number is actually optimal. I think you will find that it was just a number clutched out of thin air by neo-Keynesianists, who believed that a small amount of inflation encourages economic growth, extrapolating from the fundamental premise of Keynesiansim.

        Real inflation is a tax. It is only the government issuing the fiat currency which may ultimately benefit from inflation. To understand this you must go back to the concept of fiat money being solely a token to represent real wealth. Fiat currency does not have intrinsic value in itself. “Retail price inflation” so called is not real inflation.

        I agree entirely that price changes are not what inflation is. That is why as I have pointed out previously hereon, to attempt to measure “inflation” by only monitoring prices is a delusion. With this error if taxes are increased then supposedly measured inflation increases which is just nonsense. As you point out there are and will always be natural cycles of prices, due to scarcity, speculation and a host of other factors. That has nothing to do with real inflation when due to those types of causes; but therein lies the problem, because it is impossible if you attempt to measure inflation using only prices to discriminate between what the causes actually are. The truth is that one of the symptoms of inflation is rising prices, but that is only one of the symptoms.

        I did not suggest that changing interest rates was the way to deal with inflation. It is the semi-neo-Keynesianists who have adopted the tool of changing interest rates as the only one in their armoury to control inflation, not me. I do not agree with that approach. There are many other tools which have used in the past, such as credit controls and the gold standard. In fact if you look back at the facts, the present problems with inflation commenced and have continued since the gold standard was abolished to produce unsupported fiat currencies, so that governments then had the ability to practice the game of financing their spending partly from the stealth tax of inflation.

        Ultimately there is only one real cure for inflation. That is to cut government spending to balance with what is raised from normal taxation, and to some extent public borrowing. However so long as there are politicians, unless there is a constraint forced on them it is the easy option and the quick fix to use inflation, and they always will.

      • Hi Burak; I am glad that you agree that inflation will not cause nor could cause productivity growth. Indeed the reverse will be and always is the effect.

        It may well be that as you observe the only ultimate solution to the problems of heavily indebted countries such as Greece will be default of some kind. That has occurred in the past.

        Concerning real inflation, please see my reply to JW. Inflation IS a tax, and ultimately only the government issuing the fiat currency benefits from this tax. Inflation is not “the way to” for any economy which desires to be sound and having true growth. As even Keynes wrote all inflation is bad and is destructive. It destroys economies and destroys enterprises and jobs. It also steals from the provident to sustain the improvident. Look at Zimbabwe if you want to see a recent example of what inflation does!

        The issue of 2 % or what being an optimal inflation number I have already answered to JW. My belief is that all inflation is bad, principally because in practice it is like a drug. “We will just try it, having only a small amount” – but it is moreish and addiction to it inevitably grows, since its instant supposed fix seems good, until the hangover comes!

        It is not too late to take action to control UK inflation YET; but it will soon be too late. If nothing is done pretty quickly then I believe it will escalate rapidly, and will then become very difficult to get back under control, and that will only be possible with much general suffering. It is always the same. If you do not take the medicine prescribed then you get more sick, and the likelihood of being cured becomes less assured.

        I suggest you read When Money Dies: The Nightmare of the Weimar Hyper-Inflation” by Adam Fergusson. (What purports to be the full text is on http://university.unitedstatesliberty.org/654/textbooks/adam-fergusson-when-money-dies-nightmare-of-the-weimar-collapse/)

  4. Thanks,Shaun. These comments are illuminating. I am reminded of the one success claimed for Quantitative Easing in the UK ie that gilt yields are 100 basis points below where they would have been but for the Asset Purchase facility Fund operations. Gilt sales by the BEAPFF would presumably cause turmoil.So, I imagine they will be held until maturity or until way after this volatility is over.

    I found George Osborne’s reply to Mervyn King more interesting. Whereas, in his first reply in May he seemed concerned about inflationary expectations embedding themselves in the national psyche, he now barely gives that worry a thought. So proud is he of his austerity drive, he must think he neednt worry.

    I think JW has put his finger on something very important. Lip-service has been paid to market economics when it comes to privatised utilities and other significant supply chains eg groceries. Pricing has been/will be controlled by reference to bureaucratic umpires, often partially funded by the regulated industries controlled by a few big players. But, I also wonder whether we have a predisposition to indirectly tax too many products,commoditiies and services. In the year to July CPIY ( CPI excluding indirect taxes) rose by 1.4%.

  5. Hi Shaun,

    I have a question which goes around my mind for few days: How do you think the markets will react to Hungary’s ‘disobedience’? Will they try to get revenge on her for abandoning the IMF plan?

    • Hi Angelo
      The immediate response to her disobedience to the IMF was for her government bond yields and exchange rate to come under pressure as I reported back then. But for the time being I do not expect any great further pressure for one simple reason in general the markets expect Hungary to come back to the table in say 6/9 months. So for real pressure we would need to see a change in that view or something which affected Hungary such as the Swiss Franc going higher again. The numbers for the Swiss Franc borrowing with 1.7 million mortgages denominated in Swiss Francs in a population of around ten million worry me as I think of it again. This is Hungary’s achilles heel.
      Perhaps the real acid test would be if Hungary’s courts challenged the legality of the mortgages or restricted their impact in some way…

  6. You write that long-Term Government bonds surge. Here in the US, the 10 to 20 year US Government Bonds, TLT, surged as well; but manifested bearish engulfing today.

    In my SeekingAlpha article, 3.5 Million Squatters Live Payment Free As Banks Exercise Their FASB 157 Entitlement And Decline To Foreclose, I wrote: The currency traders went long the Euro Yen carry trade, the EUR/JPY, to keep the Euro, FXE, from falling below 127. And also went long the Canadian Dollar carry trade, FXC:FXY, and the Australian Dollar, carry trade, FXA:FXY, as they invested in base metals, DBB. The chart of base metals, DBB, shows Tin, JJT, copper, JJC, Lead, LD, Nickel, JJN, soared. Asia shares, DNH, which move, with commodities, rose strongly. The European Financials, EUFN, rose strongly on the higher Euro, FXE which induced Financials, XLF, and the Russell 2000, IWM, and the small cap value shares, RZV, to rise. Homebuilders, XHB, Material stocks, XLB, and industrial stocks, XLI, rose on the rising commodity prices. The speculation in commodities, caused Junk Bonds, JNK, and emerging market bonds, EMB, to rise. The gentle rise in stocks and currencies and junk bonds, provided an opportunity for the investor to go long by investing in Volatility, VXX, shorting a number of ETFs such as EUFN, XHB, AMJ, RZV, TAN, EWP, and the manic commodity Tin, JJT. It was a day for the short seller to increase position in 200% inverse the Russell 2000 Value, SJH, inverse of Japan, EWV, and 200% inverse of the Euro, EUO. The yield curve, $TYX:$TNX, flattened some. The US Ten Year Note, IEF, fell a little after having for nine weeks, rising from approximately 93 to 98 beginning with the announcement of the EFSF Monetary Authority on June 10, 2010. The US Government Bonds, TLT, manifested bearish engulfing. Once we have clear indication that the rally in US Government debt is over which may take up to six days of trading, it will be time to go short Financial Preferred, PGF, Ford Motor Credit Co, FCZ , California Municipal Bond, CMF, Municipal Bonds, MUB as well as Emerging Market Bonds, whose performance is affected by emerging market currencies, CEW, than anything else. And at that time it will be appropriate to go long 300% inverse of the 30 Year US Government Bond TMV.

  7. The output gap theory is no different to the theories on the Phillips curve. In reality firms will always charge higher prices rather than increase output as it has significantly less risk.
    Fundamentally asset prices are too high and instead of them falling the policy is to raise the general price level to bring back the equilibrium.

    Gilt yields are low because of excess money, inflation is higher. This will create huge tensions which will suddenly snap.

    The Bank of England has been and still is a massive failure.

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