Market Insights

Inflation risks

Carney has poured cold water on the 3 rogue MPC hikers with this morning’s release of the delayed Mansion House speech. That’s not wholly surprising given that the rate cut last August was very much driven by the Carney “Brexit Disaster” purview, and hence wouldn’t be taken back in a hurry for fear of admitting the cut was an error. Indeed, Carney can breathe a little more easily now that one of the rogue hikers, Kristin Forbes, just voted in her last meeting, and will be replaced by Silvana Tenreyro who said in January: “My pessimism regarding Brexit has not moved much: I think it will have a negative impact on the UK economy and Europe more generally”.

Forbes has left a parting gift, however. A Discussion Paper, entitled “A trendy approach to UK inflation dynamics”, suggests that the volatility in inflation is not simply driven by short-term cyclical issues. It’s a trend. The recent rally in inflation is nowhere near as cyclical as that of the 1980s or the commodity-driven boom of 2008:

trend v cyclical inflation

What is driving this trend? Well, the paper argues that the exchange rate may have a much larger impact on inflation than many think:

the one (and only) variable that consistently yields a coefficient estimate that is significant for both headline and core inflation and for the shorter and longer lag structures: the sterling exchange rate index. A sterling depreciation is significantly correlated with both higher subsequent headline and core inflation. Moreover, the magnitude of this effect is estimated to be material.

They calculate that the 20% depreciation in trade-weighted GBP last year implied an increase in trend core CPI inflation of 0.86pp. As they put it, ‘these are large effects’.

They go on to look at other potential drivers of inflation such as the output gap and inflation expectations but conclude ‘these standard measures…are… rarely significant in explaining the dynamics of core inflation’, and when they are, it’s of a small magnitude. They point out that the UK, unlike the US, is a small open economy, so the exchange rate plays a much bigger part.

In other words, the BOE ignores Sterling at their peril. We can all understand why Carney is desperate to keep rates low as the UK economy faces an uncertain future. Even more so now that we have months if not years of political instability ahead. But they face a very unhappy trade-off between the somnolent wages of an apparently dead Phillips Curve, and rampant exchange-rate-driven inflation as capital flows out of the UK economy. The tight labour market is not (yet?) generating inflation; but the exchange rate is. So to which do they respond?

Meanwhile the Fed has the opposite problem. It wants to raise interest rates, with Janet Yellen mindful that she only has two more press conference FOMC meetings in which to stamp her legacy into history (if her term is not renewed). They also face an apparently dead Phillips Curve, but no signs of inflation despite the tight labour market. The downturn in inflation is causing the doves to flutter their wings. Evans was on the wires yesterday warning that “We could wait till December” for the next hike. He went on: ‘I think if we were to race to a higher funds rate too quickly without seeing improvements in inflation, that could be quite a concern. And it’s that part that I think where we need to stop and kind of go, you know — I just think the message out of the conservative central banking story was, we need to get inflation to 2 percent’.

Then Yellen, in last week’s press conference, says that she is open to raising the inflation target, after having previously dismissed it. She suggests:  ‘this is one of our most critical decisions and one we are attentive to evidence and outside thinking. It’s one that we will be reconsidering at some future time…. But a reconsideration of that objective needs to take account not only of benefits of a higher potential benefits of a higher inflation target, but also the potential costs that could be associated with it… But I would say that this is one of the most important questions facing monetary policy around the world in the future. And we very much look forward to seeing research by economists that will help inform our future decisions on this’.

Is this Yellen the dove popping up again? Or more likely, Yellen who wants to make her legacy secure. She’s nervous now that she will exit with inflation never having reached target. So over to you the academics, you come up with some research that provides a Get Out of Jail Free card.

She, like Carney, is stuck between a rock and a hard place. She was handed the poisoned chalice of removing extraordinary stimulus without derailing the US economy. If she can just start to reduce the size of the balance sheet and get rates back to a neutral-ish level before her February exit, she will have done her job. But if inflation starts to dip? Oh dear… Charts like these will worry her:

US CPI breakdown

So, Yellen has to balance tightening policy against lower inflation. Fortunately the rally in the stock market is loosening financial conditions even as she is hiking. How long can she rely on that?

Meanwhile Carney has to balance loosening policy against higher inflation. Fortunately value hunters are happy to buy GBP near its recent lows, despite the political instability. How long can he rely on that?

We would feel sorry for them, if only their persistent “lower for longer” narrative hadn’t been a prime contributor to driving the inequality that is now spilling out into electoral rage. But that’s a story for another day. For now, both GBP and the USD face significant risks ahead.

Step Forward Big Phil

Last night, Janet Yellen shrugged off lower inflation prints as “driven significantly by one-off reductions”, while focusing more on “a strong labour market…that is continuing to strengthen” meaning that “the conditions are in place for inflation to move up”. In other words, whatevs inflation, we are hiking. Indeed, they sketched out further their plans for running off the balance sheet.

Does the market look bovvered? In a word, No. The 10 year yield made new lows for the year at 2.12%, with the 2 year edging only slightly up to 1.34%. Flattening makes sense in a world of hikes but the absolute levels are somewhat crazy. The Fed just hiked to 1-1.25%, meaning that over the next two years, rates are expected to do very little indeed. The next fully priced Fed hike has been brought forward, but only from June next year until March.

Four years after the taper tantrum, central banks appear successfully to have mastered the dark arts of sedation.

With the market so sleepy, it’s no surprise to hear that corporate bond holdings are at five-year highs. Load up on yield where you can. Even the Bank of Japan are tapering by stealth, with their government bond purchases in May the lowest since October 2014. The central banks have successfully started to withdraw stimulus without anybody noticing. What could possibly go wrong?

Step forward Big Phil: tonight the UK Chancellor makes his Mansion House speech. This should give us a reminder of the risk that cannot be priced, that of politics in all its unpredictable glory.
It is no exaggeration to say that the UK political system is now in turmoil. We have no leader and still no government. The ongoing talks being thrashed out between the Conservative Party and the DUP suggest that there are some deep-seated issues between the two sides that are making it incredibly complicated. No. The Conservatives and Liberal Democrats, much less natural bedfellows, thrashed out an entire coalition agreement in just over a weekend in 2010. And that was for a coalition, not just a confidence and supply arrangement as the DUP will provide in this parliament. No, what’s really going on is the tussle within the Conservative Party. The delay to the Queen’s Speech, when the government launches its policy programme, is due entirely to the inability to agree on that programme. Usually, a government is elected and simply implements its manifesto. This time, the predicted Conservative Party landslide turned on its heels as soon as the manifesto was released. The new government now needs to come up with policies that will shore up voter approval.

That might be possible if there were a new leader to make the decisions about what policies stay and what go. It would be possible if someone could claim to understand why the voters behaved so unpredictably, and point to a new path ahead that would shore up support for the government. Right now, there is no such person. The Conservative Party are uncomfortably aware that their power sits on a knife edge. If a minority government cannot command confidence, it opens the door for someone else to have a go. And if the other side collapses or cannot command confidence, the whole thing falls down and we have to have another election. Right now, the Tories cannot allow that to happen. They are in turmoil.

Hence the importance of setting out the stall in the strongest way possible at the start of this government. But at the exact same moment, the blame game has set in – read a great summary from the Economist of the “doomed campaign” here – while those with an eye for the Prime Minister’s job jockey for power behind the scenes.

So tonight, Philip Hammond has his moment. The annual Mansion House Speech. The setting itself bestows power: a grand room, full of City dignitaries, with a speech also from the Bank of England Governor.

With four days to go until the start of Brexit negotiations, the Chancellor can steal the initiative. Who can stop him? In a leaderless country, there is a vacuum. The person who gains momentum and coalesces support around their position can command power.

Now, Big Phil isn’t a limelighter. He’s pragmatic. He’s old school. When he moved to the Treasury, the civil servants started to wear a lot more ties. Therefore he’s not going to cause a deliberate ruckus within the party simply to win the glory. The Daily Mail already warns that “at least three Cabinet members were prepared to quit” if he rowed back on Brexit.

But he is also a businessman and he knows this is a golden opportunity to drive the Brexit debate in the direction that he believes is right for the country. If Cabinet members did quit over a ‘softer’ Brexit, then other MPs with a similar stance could easily be found to replace them. This is the quandary in which the Tory party once again finds itself: prepared to tear itself apart over Europe. In a sense, it merely reflects the quandary in which the country finds itself, as the 52-48% referendum split already showed us.

The markets have mostly decided that ‘softer’ means ‘higher’ when it comes to Sterling. With GBP also sedated by the overall market mellow mood, it would be no surprise if tonight’s speech flushed out some post-election shorts, and GBP had a decent rally.

In the longer-term, Sterling strength might not be borne out. But in the long-run we’re all dead. For now, the short-term is in vogue. Even for the Fed, where a rate hike next year might as well be a rate hike next century.
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Central Bank Euthanasia

While the UK waits for its Godot-like government to form, the rest of the world has tonight’s Federal Reserve meeting to look forward to. Except does it, really? Central Banks have taken great delight in not only propping up and intervening in the world’s financial markets, but effectively euthanizing them by doing so. Welcome to the Central Bank Dignitas: where volatility goes to die.

Tonight, for example, we face a pretty strong probability of a Fed rate hike. But with core inflation backing off, and with almost all prior Fed hikes couched in dovish terms, it would appear that its impact is almost zero. Indeed, since the Fed last hiked in March the 10 year yield is 45bps lower. Financial conditions overall are much looser, given the stock market rally and narrowing in credit spreads. Effectively any Fed hiking to date, and they are about to do their 3rd in 7 months remember, has been more than neutralised.

For that, you can thank a number of factors:

  • The pause, if not entire reversal, in the reflation trade that began when China Producer Prices broke out of a 5 year downward spiral into deflation.
  • Then the Republican “clean sweep” of US politics that was expected to deliver regulatory and tax reform.
  • The momentum of passive money looking for a home in risky assets
  • The ongoing QE from both the ECB and the Bank of Japan, which has more than made up for any pushback from the Fed

Blondemoney was astonished by the bragging from Mario Draghi on this front last week. It slightly became lost in the UK election maelstrom, but he boasted quite clearly as follows:

‘I want to emphasise that basically the ECB will be in the market for a long time’
‘You asked me about normalisation: was it being discussed? The answer is no.’

And then his final comment of the Q&A:
‘So the risk of deflation has dissipated. The recovery is proceeding based on consumption and investment, and consumption and investment are growing because of QE also – not only, but also QEBecause interest rates are low, labour income has increased; wealth, households’ wealth has also increased. Financing conditions remain extremely favourable, and this is essentially because of QEAnd the pass-through of our monetary policy decisions has probably never been as effective as it is today. So this is passed into lower lending rates, much closer spreads across the eurozone, closer spreads across sectors and between different companies. I think I’ve said in the introductory statement that the SMEs are also benefiting greatly from the QE policy and from our monetary policy measures. So I think I’ve answered fully your question.’

This is alongside the other conclusion from the ECB that deflation is dead:
‘If we look at the uncertainty dimension of inflation, we see two phenomena. The first is that tail risks have disappeared. So deflation risks are not there any longer, and that’s why we have removed one of our easing biases, which was exactly addressing the tail risks of the inflation path. And we also see that the uncertainty about the path of inflation has also decreased. So as the output gap will close and the unemployment rate will go down, we are becoming also more confident that the inflation path will converge towards our objective in a durable way.’

So, deflation is no longer a tail risk. But QE will go on and on and on. It’s just so darn effective right? Why stop?

Is this some kind of Central Bank Faustian Pact?? Draghi keeps his foot on the accelerator as Yellen lifts hers off? While they play footsie, the risk-reward of investment is becoming ever more skewed. Note this article from Bloomberg from a bond hedge fund that boasts of making 19% returns this year by investing in the safest assets: their CIO concludes:
‘“We’ve produced a higher risk-adjusted return than what the carry should justify in the positions we hold.”

Now look, let’s not blame him for exploiting market irrationality. But it is a screaming red flag about the Alice in Wonderland world in which we now live.

At least the Bank of Canada has woken up. On Monday, Deputy Governor Wilkins commentedthat they ‘will be assessing whether all the considerable monetary policy stimulus presently in place is still required’. Cue a revival in the Canadian dollar and a rapid re-pricing of the Canadian rates curve – although only ~18bp of hikes are now priced by the end of the year. Even a clear signal of at least one full hike soon isn’t enough to get it fully priced in. This is the extent of the wall of money that continues to keep interest rates depressed.

So for the Fed tonight, the surprise would be if we took the hike hawkishly. That could happen, as remember that Janet Yellen only has two more press conference FOMC meetings before her term is up. The all-important word “legacy” must be floating through her mind. It’s not hard to imagine a scenario in a couple of years’ time where any reversal in the stock market would be blamed by a potentially even-less-well-liked President Trump on the incorrect monetary policy of a lazy and incompetent Fed. She has a window of political opportunity. Throw in the hikes now Janet, while you still can!

The Election Aftermath – Now What?

Theresa May is still the Prime Minister. The Conservative Party were aware that if they couldn’t form a government, Jeremy Corbyn would be invited to give it a go, and a leadership election would take up too much time. Instead, they’ve decapitated their Queen by forcing her to get rid of her two lieutenants, and tied up an alliance with their Northern Irish counterparts to ensure a numerical majority in parliament. In return, they pledge allegiance to an entirely discredited and lame duck Prime Minister May. In the very short-term, this was the least-worst option to keep the Conservatives in power. They may live to regret it. These are some reasons why:

  1. We are now leaderless

The true power behind the PM lies in the Cabinet. She is trotted out to tell us she’s ‘getting on with the job’ while the reality is that she is entirely beholden to her party. They’re furious with her (aren’t we all?) and currently united. But government by several voices doesn’t work – hence why there is a primus inter pares of the Prime Minister. What happens when the big beasts all start to disagree?

  1. We are now without a real government

Sure, the tie-up with the DUP technically leaves the government with the numerical majority to carry on. They have opted for a confidence & supply arrangement, meaning that the DUP would vote with the government on any confidence votes, as well as supply bills that provide the money to keep the country going. However unlike a formal coalition, it means that on any other bills, the DUP can vote as they like. With many DUP MPs holding views that are unpalatable to Conservative MPs (such as opposing gay marriage) this allows room for the alliance to be flexible without breaking.

It’s not the DUP that should worry us, however. The mathematics means that the Conservative Party cannot afford any internal dissent. If 10 Tory MPs decide they don’t like the direction their party is taking, they can hold it hostage. For those who think a hung parliament means a “softer” Brexit, they should be aware that this minority could just as easily come from hardline Brexiteers.

  1. We are still leaving the EU….

Much of the weekend analysis of the shock result suggested that “it was a vote for [insert pundit’s personal preference here]”. There were certainly enough contortions to enable someone to draw whatever conclusion they liked. A vote against Brexit, against austerity, against social care reform, against evil Tories etc etc etc. Conservative gains in the North and Scotland were neutralised by Labour gains in metropolitan and university areas in the South. What conclusion can we draw from that? Very little, except that there are now a variety of dividing lines cutting across the British electorate. Within a First-Past-the-Post system, this leads to distortions. We can only say that the electorate voted for “None of the Above”, as no-one gained an overall majority.

We certainly can’t say anything with certainty on the electorate’s view on Brexit, given that the only party promising a second referendum (the Liberal Democrats) failed spectacularly badly. Their former leader, Nick Clegg, lost his seat, and their current leader, Tim Farron, came within 778 votes of losing his. (For those worried about the social views held by the DUP, Tim Farron has been accused of holding similar views).  The view of the country on Brexit is probably just as confused as that of its MPs. One year on from the vote and it’s still not entirely clear what a post-Brexit Britain looks like. Or even vaguely clear. Part of that is because the EU wouldn’t openly negotiate until Article 50 was triggered; and then since then we have had the election to deal with. The electorate can be forgiven for being asked to vote before they knew more about what life outside of the Single Market might look like.

  1. ….or at least we are still leaving the EU at this stage

Blondemoney had considered the Brexit vote to be the end of the matter. We were out. However, now that we are entering a period of significant uncertainty, nothing is off the table. If we think markets don’t like uncertainty, how are the people of this country going to feel after a few months of leaderless, directionless government? If (when) the government falls, and if (when) the economy tanks, and if (when?) we get a former-Communist Prime Minister, and if (when?) we get a currency crisis, we might find that the British electorate will be desperate to run back into the comforting arms of the EU.

  1. The economy is already vulnerable

It’s striking how little the economy was discussed in this election campaign. It’s as if debts and deficits just disappeared as an issue. Now, part of that is because economies have been growing again, and debts are being paid down through austerity measures. Part of it is just time. The further away we get from Greece’s bankruptcy or Bond King pronouncements that Gilts are sitting “on a bed of nitroglycerine”, the less of an issue it becomes. Then Donald Trump is elected, tax reform engulfs us, and it appears we can hit the stimulus button once again.

Alongside this is the calm in the bond markets. There are no bond vigilantes to bully us when the world’s central banks are indulging in perma-QE. Let’s not forget that the Bank of England re-started its QE programme last summer. A few years ago, voters were told they had to take the pain or their countries would go bust. Now, they’ve taken the pain, and all that they have seen is asset prices go up, the rich getting richer, inequality widening, and no end in sight for stagnant pay. The puzzle over the lack of a Philips Curve is therefore not just an esoteric issue for a central banker. The voters feel it too. They may be getting a job, but they’re not getting richer. In fact, in the UK, their purchasing power is plummeting thanks to a Brexit-induced weaker pound.

So, the UK is a deficit country, still. It already has inflation, but not of the helpful kind. It has a weak currency that thus far has encouraged foreign investors to get UK assets cheap. But now, we enter a period of massive uncertainty. Will foreign money continue to plug the deficit gap? How will we fund the deficit? How will we maintain fiscal discipline with a government that will struggle to govern? Or indeed when a government turns up that wants to tax-and-spend?

In conclusion…

The range of future paths for the UK economy just increased significantly, and almost all of them are negative. Blondemoney is an optimist, but right now it’s tough to see a positive outcome. This is exacerbated by the politics of it all. It will now be in all of the politicians’ personal interests to arrive at a crisis. The only way for anyone to become Prime Minister with any authority is for the situation to become so bad that they are begged to save the country from disaster.

No-one wants to plunge the country back into an election campaign. No-one in the Conservative Party wants a leadership election yet. Anyone who wants to be leader will want to be asked to do it, rather than put their hand up – given that they will only be chosen by Conservative Party members, yet need to run an increasingly divided country.

On the other side, the Labour Party just needs to watch and wait in the wings. It may not look like they have the numbers, but if the Conservative Party split, over, I don’t know, a really divisive issue like, say, Europe, then anything is possible. You don’t need the numbers if you can dare the other side to club together and vote you down. Plus the Labour Party might get more numbers than it looks – could Sinn Fein renounce their convention of not taking their Westminster seats in order to do so?

Do not even rule out Blondemoney’s father’s prediction of a GNU (not least because he has been right about all the big calls in the past year). DadMoney warns that it will be so difficult for anyone to govern that the Conservatives and Labour might as well club together to work it out. A “Government of National Unity” was mooted in the last minority government crisis of 1974, and has taken place during periods of great challenge for the UK, such as after the Great Depression or during the Second World War.

For now, let’s see how the start of Brexit negotiations and the Queen’s Speech go in a week’s time. But beyond that, dark times appear ahead.

 

DisMayed

Well well well. Yesterday we asked whether Theresa May was about to win an audacious gamble, or whether she would go down in history for all the wrong reasons. As I type, the numbers are likely only to stack up for a Conservative minority government, propped up by their friends in Ulster. It’s possible that Labour might try to round up everyone else against that, but it’s unlikely. Although perhaps nothing should be ruled out – including a GNU. Not a flightless bird, but a Government of National Unity. A grand coalition of Labour and Conservative, to take us through the Brexit challenge. Well, it worked during the Second World War…

Let’s focus first on what we know:

  1. This will be a hung parliament

The Government in power gets the first chance to form a government. If it doesn’t work, the PM has to resign. So, we have at least a few days, if not weeks, to thrash out who is actually running the country. A confidence-and-supply arrangement could come in: this is where another party/parties agree not to vote down the government on a vote of No Confidence, as well as submit to vote through their supply bills such as the Budget. Either way, minority governments tend to be shortlived, even without having to take on as significant a process as leaving the European Union.

  1. Theresa May will go, in some way, at some stage

Given Brexit negotiations start in 10 days, and a leadership election will take time, she may need to call for a caretaker period. A leadership election would be required, as she became leader unopposed, and in seeking a mandate she led us into this mess. But pressure on her will become enormous. As BM’s General Election Preview noted:

She sought to unite the country behind her, personally. Any campaign rally was festooned with posters declaring “Vote for Theresa May’s Team”. It’s not a vote for the Conservative Party, it’s a vote to strengthen the hand of Britain when Theresa May goes to the negotiating table… It would be interpreted that the electorate looked at ‘Theresa May and her team’, and didn’t much like either.”

The brand is destroyed, and thus so are her lieutenants, like Amber Rudd (who only snuck into her own seat after 3 recounts). That means a rejig is required in the Cabinet too.

  1. Brexit negotiations are under threat

The purge at the top will be required, because otherwise our opponents at the Brexit negotiating table have the upper hand. As we noted:

[anything less than a majority] would severely weaken her negotiating hand. Not just in terms of the numbers of MPs and voters who support her, but in terms of perception. The other side of the negotiating table will know:
1) She gambled and failed – suggesting she raises the stakes at the wrong moment
2) She couldn’t unify the country– suggesting the court of public opinion is flexible
3) She couldn’t unify her party – suggesting she misjudges her political capital’

There are many who will claim that this result shows the UK public didn’t want Brexit after all. However the results are far too nuanced for that. Labour won Canterbury for the first time ever; but the Conservatives won in traditional Labour heartland Stoke South. Both Tory and Labour MPs increased their majorities, but equally some were slashed to almost single digits. It looks like the UKIP vote went over to Labour more than had been anticipated.

  1. Brexit is still going to happen

If only we could stop talking about “hard” and “soft” Brexit, but we can’t. The reality is that there is no mandate for either of these; just for us to leave the EU in as sensible a fashion as possible. That mandate still exists. The only party explicitly calling for a 2nd referendum were the Liberal Democrats – who were demolished still further, with even Nick Clegg losing his seat.

Equally, with a smaller number of MPs, the Conservative Party will remain hostage to its Eurosceptics. They won’t let May calling this election steer them away from their decade-long heartfelt desire to leave the EU.

But with the Ulster MPs likely required for the minority government to function, they may make significant demands over how Brexit looks. Particularly as they are the only part of the UK with a land border with the EU. They cannot stop it happening altogether though.

  1. Uncertainty just went through the roof

We flagged it up yesterday. This was the pre-election “spike” in volatility:

This was caused by generally low level of cross-market volatility, coupled with an inability to price in political risk. As well as the ongoing success of “Buy The Dip”. The risks were out there, but ignored. Now, knowing the result, we enter a hugely uncertain period. We must consider the chances of:

  • Another Election this year
  • Another new Prime Minister, third in 2 years
  • No mandate for the new PM until that election
  • Disorderly Brexit

The market wants to continue to ignore this. Already I’m told to buy GBP because the risks of a “hard” Brexit went down. This, after GBP rallied when Theresa May called the election because it would strengthen her hand! The fact is that GBP is now brimful of risk premium. The outlook for the leadership of the UK is wrought with uncertainty. That leads to issues over whether to invest here, and over how the economy might perform. There’s a 2 year timetable to leaving the EU; 3 months in, and we face a Tory leadership election plus another possible General election that might take another 6 months out of that timeline. That leaves not much more than a year to get a deal done. And meanwhile, the UK still has a deficit and still relies on inflows in order to finance it. Perhaps we should even add a currency crisis to the list of potential risks.

In conclusion…
The UK faces huge challenges ahead, not least to figure out how and why this happened. The irony is that two-party politics is back, with the smaller parties diminished. That means that the Conservatives look to be winning a similar vote share to Blair in 1997, but with only two parties to fight, you need >50% to secure a majority.

As flagged in the General Election report (please email if you’d like a copy):

the collapse of the votes for the smaller parties…has created a very unstable and unpredictable system. Are those voters now wedded back to the two main parties, or unhappily flip flopping between them?

The financial crisis threw all the puzzle pieces up into the air. They haven’t fallen back to earth yet. We still don’t have the answers to the big questions. What are the Conservative and Labour parties and who do they represent? What are the big issues of the day, when 52% of the electorate ripped us out of a network with our closest trading partner? Immigration or public services? How will we pay for it – higher taxes or cutting spending?

We want change, and the current system of parties and candidates is straining to cope.’

The real conclusion will come many years from now. Until then, it’s going to be an uncertain path ahead.