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.
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.
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.