Has Jean-Claude Trichet, president of the European Central Bank (ECB) assumed the role of the world's most important central banker? Certainly his explicit comment regarding the strong likelihood that regional base rates might have to rise as early as July set the house on fire, prompting an immediate and aggressive response from senior US officials including the president himself.
Fearing that the consequence of higher European rates would be to drive the euro higher against the dollar (or the latter into further freefall against the euro, having already depreciated by c40% over the past four years), US big hitters came out swinging. Mr Bush, Mr Paulson and Dr Bernanke have all gone on record over the past few days to warn that rising inflationary pressure might have to prompt a monetary response.
Treasury Secretary Paulson specifically stated that foreign exchange intervention "is never off the table" which must mean, in the current context that it is absolutely on the table as a possible policy option, taking us all the way back to 1995 and a dollar plunge below Y80.
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Meanwhile the Bank of England remains resolutely aloof but for how long? Financial futures are now pricing in a European rate hike as a racing certainty. Over in the US, futures pricing indicates a 78% likelihood of a Fed rate hike at the October 29th FOMC meeting, a 63% chance of a hike on September 16th and even a 25% chance of a hike as early as August 5th. Were we imagining it, or did the US unemployment rate rise sharply to 5.5% recently?
Here in the UK short sterling futures are forecasting a % point base rate hike, to 5.5% by the end of the year. We cannot be more explicit when we say that if this happens recession will be the inevitable consequence and the Labour administration might as well give up its hope of retaining power at the next general election (by May 2010 at latest) right now.
On the other hand, perhaps the markets have got ahead of themselves. Whilst we accept that inflation concerns are running hot at present the argument for a preemptive strike on the part of Western central bankers is by no means convincing.
Before looking at the debate we remind readers of our early January 2005 Week in Preview publication entitled "Backing Winners". In our opening sentence we stated that "As usual at this time of year, the press is full of articles regarding what investors should expectThe professional investor adopts a different approach. To assess how best to make money from markets professional investors are increasingly looking into what is being priced into markets by reference to futures pricing now. By overlaying one's own perception of how one feels the markets might perform it is possible to form a view as to whether the markets are right or wrongand invest accordingly".
This looks like a very good opportunity to reassess the inflation outlook in the three major Western investment destinations.
Inflation outlook: UK
According to the Bank of England's latest quarterly inflation forecast, published in May, domestic CPI is forecast to peak at around 4.0% year on year, later this year. Given the latest spike in energy prices we believe that there is a strong chance that that figure could prove too conservative. Bank governor Mr Mervyn King has already forecast that he might have to write a series of open letters to the Chancellor explaining why inflation has broken out of the envisaged 1%-3% target range over the two year forecast horizon, indeed the first letter might come as early as next week.
In such circumstances a base rate hike certainly makes any letter of explanation all the easier to write. Secondly, we could be wrong about the outlook for UK economic activity. We currently expect the UK economy to grow by c1.7% this year, broadly in line with the OECD forecast.
Over recent weeks we have become much less convinced by this number and have openly speculated on the possibility of a domestic recession either in late 2008 or in 2009. If the credit crunch really has passed over and confidence returns then maybe we might have to reassess our growth outlook. Thirdly, we might see a rise in underlying (core) inflation. Up to now inflation has been limited to rising energy, food and utility prices. However, the spike in producer output prices at the factory gate indicates that inflationary pressure might be spreading. If this were to manifest itself in a rekindling in the labour market's wage expectations that really would require urgent remedial action.
However, it is important to stress that at prevailing levels domestic monetary policy is already restrictive and even if rates were not cut (sterling's weakness might be said to be doing the Monetary Policy Committee's work for it) we would still expect activity to slow, additional surplus capacity to emerge and act as a natural curb on potentially inflationary wage demands.
We therefore hold to the view that core inflation should remain quiescent and that the Bank can hold the line for now, as long as it holds its nerve. Such an outcome would likely reduce tension at the short end of the gilt-edged yield curve and prove a fillip for equities, even if the very near-term were characterised by a high degree of nervous anticipation.
Inflation outlook: USA
So, the pending home sales data is now more important than the non-farm payroll! Sounds odd but the former's 6.3% increase, its strongest monthly increase since 2001, emerged just as US officials moved to back up the dollar with hawkish rhetoric. Extraordinary activity in the US Treasury bond market saw the yield on the 2-year bond rise by 33 basis points in one session, its biggest one day increase since 1996 (a year of no recession and no credit crunch).
It now seems certain that, notwithstanding the weak May employment report the Fed is preparing the markets for a move towards a tightening bias to monetary policy at its 25th June Open Markets Committee meeting. Just as in the UK view, inflation's pernicious impact on underlying CPI has been pretty limited to date. This is significant as the yield on the long bond held steady at 4.63%, a welcome reminder in all this madness that underlying inflationary pressures remain as well contained in the US as they do in the UK.
In short, we would be very surprised if the US opted for a premature strike against prevailing inflationary pressure while the economic landscape appears so parlous. Dr Bernanke is deeply versed in the events surrounding the 1930's depression and would, we suspect, be unwilling to sanction a move which might be seen as bringing those conditions one step nearer.
That said, there is little doubt that his view is by no means universally held on the rate setting Open Markets Committee. In particular Dallas Fed chairman Fisher has been outspokenly hawkish of late and whilst the rising unemployment rate may stay policymakers' hands for now investors can certainly expect an uptick in hawkish rhetoric over the months ahead.
It is also interesting to note that comments aimed at propping up the dollar had the effect of prompting a marked sell-off in the commodities complex. We have regularly drawn attention to the inverse relationship between the two and if the dollar really has turned the corner (which we are sceptical about) then we might expect to see further weakness in oil, gold and other scarce raw material prices.
Inflation outlook: Eurozone
Although we take the view that the ECB's rate setting council have already taken the decision to raise regional base rates at the July meeting at least one Executive Board member, Mr Jurgen Stark has indicated that the move, if it comes, might only be a one-off. As a clear attempt to dampen speculation which saw regional short-dated bond yields move aggressively higher. Mr Stark's comments have made little difference.
Essentially, this reflects the fact that financial market operators had viewed a rate hike as highly likely (if not inevitable) for some time. Whilst accepting that the euro's strength is likely to limit inflationary pressure, we must now accept that our previous view, that regional rates would remain on hold over 2008, is looking somewhat out of date.
We accept the candour of Mr Trichet's comment that the ECB's governing council were far from unanimous in coming to the decision and view that conclusion as inevitable given vastly different pressures impacting member countries at the same time. The key question is whether a 0.25% point hike in rates, to 4.25%, will be enough to keep inflationary forces under control and whether it might be able to do so soon enough. Economists' models tend to indicate that a 100 basis point base rate hike cuts inflation by c0.1% - 0.3% points in year two and by 0.3% - 0.5% points by year four.
Whilst we view a whole 100 basis points as very unlikely, it is certainly possible that regional rates will rise by 50 basis points and possibly as soon as Q4 2008. With the outlook for regional growth uncertain we judge the risks of eurozone rates at 4.25% by year-end as being roughly the same as the risk that rates will be at 4.75%. Mr Trichet has repeatedly indicated that, in his view, the region's economic fundamentals are sound even if the ECB's own projections for growth do indicate that additional surplus capacity will emerge as activity comes off the boil as the year progresses.
Finally, we believe that the ECB will want to drive home its credibility as a rate setting organisation for the eurozone as a whole and the wider world (maintaining a strong history of such action at the Bundesbank). Mr Trichet would not make so bold a pronouncement simply to test the financial market's resolve. So overt a comment must now be followed up by policy action. The question for investors is whether the gradient of the bond yield curve inversion is appropriate or whether the knee-jerk move to drive short-dated bond yields higher was an over-reaction. For now we are less convinced about the value in European short-dated than we are about the US and UK bond markets.
Conclusion
Mr Trichet's candour has fuelled dramatic responses from the Anglo-Saxon economies resulting in a sharp rise in short-dated bond yields. We don't believe that the US and UK central banks have the stomach for rate hikes, despite the perceived near-term inflation threat.
Indeed, it is our view that were verbal intervention sufficient to alter the course of the dollar some of the speculative froth in the commodity markets would blow off. Economic activity is slowing and our perception is that weakening demand should, all things being equal, result in lower commodity prices and hence lower imported inflation. Underlying inflationary pressure, although never to be taken lightly, remains quiescent indicating that if there is a big inflation "nasty" out there this is not it.
We are more concerned about what happens when global economic activity resynchronises in the next upturn. That, we suspect, is when normal economic cycle conditions will re-assert themselves. At that point central bankers will need to be very much alive to the underlying inflation threat.
This article first appeared in the Week in Preview published by Charles Stanley Stockbrokers
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