We take the view that inflation is a lagging indicator and deflationary pressure, the consequence of deflating asset prices, is the more pernicious issue for the future.
In that context and given that the US Federal Reserve is clearly more concerned about the growth outlook and propping up an ailing Wall St. we were surprised that the accompanying statement to the Fed's latest base rate reduction (Fed Funds rate down to 2.25%, Discount rate down to 2.5% on 18th March) was so hawkish, much more so in fact than the late January communiqu which seemed to play down inflationary pressure.
What we also know is that there were two dissenters to the latest rate cut on the Open Markets Committee (Dallas Fed chairman Fisher and Philadelphia Fed Chairman Plosser). Both are known hawks and it could be that the statement has their finger prints on it rather than those of Fed Chairman Ben Bernanke. We will know better what Mr Bernanke himself thinks about the latest, tumultuous events in the financial markets when he addresses the Congressional Joint Economics Committee on 2nd April.
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What we also know is that, despite official support for the long-term health of the US economy and the dollar (which one would expect during times of uncertainty), the latter has been falling hard on the world's foreign exchanges for quite a while. A falling dollar, in part the consequence of US monetary policy, is helping to fuel inflation thus reducing real incomes and depressing spending. Although February's consumer price inflation (CPI) was unchanged from January, core producer price inflation increased by 0.5% over the month, its fastest rate in 17 months, for a 2.5% year on year increase.
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At the same time as the dollar falls so US Treasury bond yields collapse. On 17th March the yield on the 10-year US Treasury fell to just 3.30%, i.e. below the levels it reached in the immediate aftermath of the Fed's emergency 0.75% point reduction in the Fed Funds rate back in late January. The yield is now back down to the levels last seen in June 2003, again immediately before a Fed rate cutting meeting.
At that point the Fed signalled that the process of monetary easing was over, triggering a marked rise in yields. On this occasion we cannot feel quite so comfortable. At the time of writing risk aversion continues to run high across financial markets. The TED spread (interest rate differential between 3 month Eurodollar and 3 month Treasury contracts) remains at an uncomfortably high 160 basis points (only just off its 163 basis point high achieved in early March) and credit default swap spreads continue to stand at an equally elevated 185 basis points. There was nothing in the accompanying statement to encourage investors to believe that the process of base rate reductions has come to and end and thus bond yields, whilst offering nothing for longer term investors, continue to reflect short-term safe haven interest.
Back in the real world falling bond yields have great significance. Through its policy actions the Fed is attempting to manage the fall-out from the credit crisis and keep the US economy on an even keel. The dollar's weakness is a reflection of policy action and one which should, in due course, provide an excellent platform for the country's exporters to benefit. Although the US trade deficit has been falling over the past six months, it remains stretched (at c4.9% of GDP) in the context of history. This means that the US has to continue to attract financial flows from overseas to prevent an all-out balance of payments crisis developing.
For many years the rest of the world was happy to park its resources in the US Treasury bond market but as prices have risen and the dollar has fallen so global investors have woken up to the view that they are investing in a devaluing asset. In an ideal world global investors should naturally switch their attention to US equities, however, near-term inflationary pressures (coupled with the weakening dollar) indicate that this is not yet happening.
As far as global asset allocation is concerned this looks like being the next big call. Charles Stanley's view is that at some point over Q2 investor risk appetite is likely to return. That could mark quite a turning point for the dollar which we believe will have a markedly better H2 2008 (particularly against sterling) than it experienced in H1. By extension we expect US equities to perform disproportionately well against other global equities and would be looking to build weightings to the US on a gradual basis.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley
