In the US they're arguing how best to deal with it...

Monday 17th October 2016

In the US they're arguing how best to deal with it, in Europe they're struggling to remember what it looks like , and in the UK it looks an oncoming avalanche..... it's inflation, of course.

ref:- "Government Bonds in US, Europe Under Selling Pressure Again", Wall Street Journal, Markets / Credit Markets

We were on the road at the end of last week and missed two contrasting days of action in credit markets on Thursday and Friday. Broadly speaking, bonds prices had been on the decline (and bond yields on the rise) for several weeks on the back of a growing perception that the day when central banks run out of the ammunition to keep bond-friendly monetary policies going is approaching. It may even be the case that they begin to question the wisdom of continuing the expansion of stimulus measures even if they were in the position to do so. Thursday saw something of a rally in prices and dip in yields as poor export numbers from Beijing saw the possibility of a China-led global slowdown come back into focus. It didn't last long, and the move was more than reversed on Friday and early this morning as inflationary wholesale price data in both China and the US assumed centre-stage, and markets pondered over the implications of higher oil prices.

The plunge in the value of the pound and what it means for UK inflation is a subject we've already discussed, and it's fair to say that if it's taken until this weekend for the nation as a whole wake up to what a truly "hard" Brexit might bring then the stark reality of Britain's position is unchanged.  10yr Gilt yields have touched 1.20% this morning (just 0.52% on Aug 12th, remember) and tomorrow's Consumer Price Index data will be closely watched : Sept CPI Y-on-Y generally expected at +0.8% (though +0.9 in very much on the cards) after +0.6% last month, and Sept Core CPI due +1.4% after +1.3%.

Whilst it's true that in this post-Brexit world the UK (along with its currency and sterling-based assets) should be treated as a separate entity, it's also true that the huge moves in its government debt markets have influenced other equivalent markets across the developed world. German 10yr Bund yields hit the giddy heights of +0.10% this morning after trading at -0.15% less than three weeks ago. As we write, the market has given back a couple ticks after Eurozone inflation data came in exactly in line with expectations  --  Sep CPI +0.4%, Sep Core CPI +0.8. Frankly, recent upside moves in yields seem to have much more to do with the perceived intentions of the ECB and spillover impetus from other global bonds than any great inflationary threat in Europe. For their differing reasons, authorities and investors alike will be searching for genuine signs of inflation but convincing evidence of its long-awaited return is still lacking.

In many ways the most interesting action of recent days has been in US Treasuries  --  the 10yr note was yielding 1.81% at one point this morning. Fed Chair Janet Yellen spoke last week and whilst all the talk had been about how close a call it had been to refrain from a rate rise in September and about how she was going to prepare markets for a hike in December, Ms Yellen failed to discuss the timing of a move at all. In fact, she suggested that monetary policy should remain highly accommodative to boost the economic recovery.

You might well think that such an accommodative position must be supportive of bond prices and push down yields, and far more often than not you'd be right ..... but on this occasion it's not that simple. The hawks have been rattling their cages about the need to start the rate-raising cycle precisely to keep a lid on inflation BEFORE it becomes a problem, and Ms Yellen is suggesting that the Fed should be prepared to allow inflation to exceed it's 2% target rather than jeopardise the recovery. As we know, because it eats into future fixed returns inflation is bad news for bond prices, and traders have been concentrating more on that than the beneficial effects that easy monetary policy might have in an atmosphere less preoccupied with a pick-up in inflation. 

More than a few investors have been translating that scenario into their trading policy  --  if you think that short-term rates are going to remain easy after all, and that consequently we'll see a rise in inflation, then the obvious thing to do is to buy short-term debt (e.g. T. Bills etc) and sell the long end (e.g. T.Bonds). It also happens to fit quite nicely into the view that as central banks run out of options, the emphasis will switch from monetary stimulus towards fiscal stimulus  --  in other words, government spending that would need to be paid for by the issuance of new government bonds.

It's not the first time that Ms Yellen has brought up the possibility of allowing an over-run in the inflation measure. It'll provide for another fascinatingly heated conflict of views both within and outside the Fed if it proves to be true, but in the absence of any earth-shattering new developments you can't help feeling that Ms Yellen might be expending too much of her credibility if the Fed fails to act yet again. Besides, it would just mean that we'd have to go through the whole process yet again in early 2017, which is a dire prospect indeed.

*** Incidentally, Bank of England Governor Mark Carney has also been talking about allowing inflation to over-run its 2% target  ..... as well he might, as it's likely he'll have little choice in the matter. Given the slump in Sterling, future inflation is a given but the last thing he'll want to do is to further undermine a UK economy that may be suffering from a "hard" Brexit by ramping up interest rates. And Janet Yellen thinks she's got problems......