The one to keep an eye on (for disinflationary pressures)…

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Since mid-April investors have witnessed a sharp reversal of many of the market trends associated with the European Central Bank’s (ECB) quantitative easing (QE) program, as the euro strengthened by over 5%, 10-year bund yields rose to levels last seen in December, and risk assets sold off. Overall, financial conditions in Europe today are now only marginally easier than they were at the time that the ECB unveiled its QE program on January 22nd 2015. We have tended to downplay explanations of the QE trade reversal that are based on fundamentals or concern that the ECB might end its asset program early. Overall there has been little in the data flow that would point to an improving outlook for the Eurozone since the rates selloff began. Market- or survey-based gauges of the inflation outlook have firmed a bit recently, but still evince little conviction among the public that inflation will return to the ECB’s target over the next several years. As such, there is little reason to doubt the ECB’s commitment to its asset purchases. If anything, ceteris paribus, the recent tightening of financial conditions increases the probability that asset purchases will continue past September 2016.

A number of events in the first week of May combined to halt the rise in developed market sovereign yields. In Europe, March German industrial production came in below consensus forecasts, and the April payrolls number in the US was consistent with a slowdown in the pace of job creation in recent months following a torrid fourth quarter. Finally, in the UK the Conservatives secured a majority in the House of Commons, to the surprise of many in light of recent opinion polls pointing to a coalition government. With a mandate to form a single-party government, the Conservatives should be able to implement fiscal consolidation, which through its dampening effects on growth could lead to marginally easier monetary policy. This development provided some support to the UK gilt market on Friday and contributed to improved sentiment in global rates. While the certainty provided by a single-party government was bullish for UK assets in the immediate aftermath of the election, the medium-term outlook could be much less clear given a likely referendum on the UK’s EU membership. With the added leverage of a parliamentary majority, Prime Minister Cameron’s future efforts to negotiate concessions with the EU ahead of a referendum will at the very least serve as a distraction to investors and business leaders, and could result in somewhat higher risk premia and dampened capital investment.

The back-up in developed market interest rates, US payrolls, and the UK election all have the potential to distract from an arguably more important development in recent days – the decision by the People’s Bank of China (PBOC) to cut benchmark interest rates for the third time in six months. Chinese monetary policy is critical for the global inflation outlook because a not insignificant portion of the world’s disinflationary pressures emanate from China, given its significant weight in the global economy.

Comparisons to the US and the Eurozone help to frame the issue. In the United States, growth has been above potential for a number of years, aided by aggressive monetary policy and progress in household balance sheet repair. Consensus forecasts call for a gradual firming of inflation as the economy passes the full employment mark later this year. In Europe, the combination of lower oil prices, a weak euro and QE appear to have placed output on a firmer path to its potential growth rate. By contrast, Chinese growth is slipping further below potential, leading to downward pressure on inflation. Strikingly, real policy rates in the Eurozone and the US remain at or below zero as a result of easy monetary policy and despite lower inflation over the past year. In China, real policy rates are above zero even after the latest rate cuts, and are quite elevated for an economy experiencing a growing negative output gap (see exhibit one below).

Exhibit 1: Real policy rates in China, the eurozone and the United States of America for the period from January 2013 through May 8, 2015.

exhibit one real policy rates

Source: FFTW calculations, as of 8 May, 2015

This is not to ignore the challenges facing Chinese authorities. More significant easing risks fueling additional speculative credit growth, and could also prompt a further increase in the pace of capital outflows. This perhaps explains the apparent preference for more targeted easing measures than the blunter tool of changes to key deposit and lending rates. Still, real short-term rates remain restrictive of growth. The PBOC will likely need to cut interest rates further, perhaps significantly, to ensure that the slowdown does not become more pronounced. The implications for the global inflation outlook should not be underestimated.

Steven Friedman

Senior Investment Strategist

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