Validus Risk Management Ltd. Volume 4, Issue 16. Risk Insight. Navigating Market Risk April 22nd, So, where s the inflation...?

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Noel Horton
5 years ago
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As inflation is traditionally a key driver of financial markets, particularly FX markets, commodity prices and interest rates, it is worth asking whether we ve entered a new economic paradigm, in

1 Validus Risk Management Ltd. Volume 4, Issue 16 Risk Insight Navigating Market Risk April 22nd, 2013 The Big Picture So, where s the inflation...? One of the supposed mysteries of the post credit-crisis era is the lack of inflation, despite the unprecedented expansion of central bank balance sheets. As inflation is traditionally a key driver of financial markets, particularly FX markets, commodity prices and interest rates, it is worth asking whether we ve entered a new economic paradigm, in which the link between money supply and inflation has been permanently weakened Last week, the IMF published a paper entitled The dog that didn t bark: Has inflation been muzzled or was it just sleeping? The paper, which poses the question of why inflation in developed economies has been so stable in the wake of the financial crisis, is particularly timely, as the ongoing battle between the supporters of austerity and those who favour the Print Borrow- Spend (PBS) model of economic growth has become especially heated due to the Rogoff - Reinhart controversy, which cast doubt upon the results of their widely cited study, frequently used to support the proausterity view. However, in addition to Rogoff-Reinhart and other economic studies (the importance of which have been greatly exaggerated in any case economics is much more akin to religion than it is to science; economists will tend to use their analysis to prove their pre-existing beliefs, and politicians will simply pick and choose from the wide range of available economic theories available to support whichever position is politically expedient at the time), inflation (or the lack of it) has been one of the main battlegrounds for pro and anti austerity factions. Those who favour PBS argue that the lack of inflation is a sign that more printing and government spending is needed to stimulate economic growth ( aggregate demand in economist-speak), and that there is clearly capacity to do this (as the lack of current inflation signifies that the output gap, the difference between actual and potential GDP, is large enough to cope with the expanded money supply without creating inflation). Those who favour austerity will counter that you cannot judge the impact of current policy by current conditions alone; the repercussions of bad fiscal and monetary policy decisions made now may not be felt immediately but that does not make them any less dangerous.

2 We really don t understand what s happening in advanced economies. Monetary policy has not been as effective as we thought. Lorenzo Bini Smaghi Former ECB Board Member Risk Insight As Milton Friedman argued, inflation is always and everywhere a monetary phenomenon. So, in light of the fact that central banks have expanded the monetary base dramatically since 2007 (by about 80% in Europe, almost 250% in the US, and by a staggering 400% in the UK), the mystery of missing inflation is indeed a valid issue to be raised with those (such as us!) who cite inflationary risks as a reason to be cautious of expansionary monetary policy. However, in our view, there are three solutions to this mystery: 1. Current inflation is actually higher than reported. The question of whether CPI is an accurate measure of real inflation is too long and complex to get into here, but suffice to say that it is a hotly contested issue in economic circles, for several reasons. An especially important point, in our view, is that that CPI methodology does not measure the value of a fixed basket of goods and services (as is often assumed); rather, it measures the cost of maintaining a constant standard of living. As such, items which gain in price (e.g. steak) can be substituted for lower price replacements (e.g. pork). This can clearly cloud the impact of inflation upon purchasing power. In fact, studies done in the US show that by using a fixed basket of goods to measure CPI, reported inflation would increase from about 2% to between 5 and 8%! 2. Inflation is simply showing up in different places. In addition to the likely under-reporting of inflation as described above, inflation is also showing up in places other than current consumer prices, such as: Emerging markets Many emerging markets are currently experiencing high levels of domestic inflation, which they contend are linked to the loose monetary policies of the developed world. For instance, inflation in Brazil is currently running at between 6.5 and 7%, resulting in last week s Brazilian rate hike to 7.5%. Asset Prices Instead of directly impacting consumer prices, money is flowing into asset prices such as property (e.g. possible housing bubbles have been identified in markets such as Canada, China and Australia) and equities (both the S&P 500 and the Dow hit record highs this 2 month, despite a relatively sluggish US economy). 3. Inflation takes time. In our view, this is the most important point. The argument of the inflation hawks is not that hyperinflation is right around the corner. Rather, it is that the conditions that are being created today create inflationary risks for tomorrow. About 10 years ago, before he was the governor of the Bank of England, Mervyn King studied the relationship between the growth of the monetary base and inflation in 166 countries from 1968 to Whilst he found the correlation between the two variables was relatively weak over short time horizons (i.e. up to 2 years), it became nearly perfect over longer periods (e.g years). As the great experiment in monetary base expansion by global central banks began about four or five years ago, it would still be considered early for any action by central banks to actually generate real inflation, as measured by consumer prices. These findings have been supported by several other pieces of research, and significantly weaken the argument that today s supposed lack of inflation justifies further quantitative easing and expansionary monetary policy. We expect that the questions of whether inflation is a real threat, or an imaginary bogey-man used by proausterity economists and politicians to further their own personal agendas, will remain a hotly contested issue for the foreseeable future. Even the IMF paper seems unsure: it concludes that highly accommodative monetary policy remains appropriate as long as inflation expectations remains firmly anchored (which sound suspiciously like saying the inflation will not be a problem until it becomes a problem). Perhaps former ECB executive board member Lorenzo Bini Smaghi summed it up best at a recent IMF conference entitled Rethinking Macro Policy II, when he noted: We really don t understand what s happening in advanced economies. Monetary policy has not been as effective as we thought. More humility like this, and less hubris from those looking simply to score political points, would be welcome from all sides in the current debate.

3 GBPUSD Key Influences Summary: Last week saw GBP/USD continue to trade a tight range between 1.52 and UK data was plentiful, but gave little in the way of fresh insight into how the economy fared in the first quarter of The news that ratings agency Fitch followed Moody s in downgrading the UK s credit rating came late on Friday although the direct impact on sterling has been minimal. Key Influences: UK expected to avoid triple dip recession The first estimate of Q1 GDP, due to be released on Thursday, is expected to show that the UK economy has narrowly avoided a triple dip. In the wake of last week s employment numbers for February/March, coupled with the release of March s retail sales figures, the consensus forecast is for GDP growth of 0.1% in the first quarter. Fitch downgrades UK credit rating Last week ended with the announcement that a second rating agency, Fitch, has stripped the UK of its prized AAA credit rating citing weak growth and the disappointing results of austerity. One positive note [for George Osborne] was that the agency kept the outlook on its new rating as stable citing continued policy commitment to reducing the underlying budget deficit. US economic outlook Although last week s data calendar was void of any major releases, a much stronger than expected increase in US housing starts has fuelled optimism that the US economic recovery can continue in the months ahead. Meanwhile, CPI data showed that inflation continues to remain subdued, suggesting that there remains little pressure on the Fed to scale back its ultra-loose monetary policy stance any time soon. Key Levels: Support Support RESISTANCE Resistance 2 Technical View: Having held steady last week with the boundaries of recent parameters, there is little change to the outlook from a technical perspective. At this stage, there is still a short term upward bias although from a bigger picture perspective, this rally continues to look corrective within the longer term downward trend dating back to the beginning of the calendar year. Rallies are expected to continue to find heavy resistance on approach to In contrast, support is evident towards but as previously highlighted, we continue to feel that longer term risks remain skewed to the downside and for a retest of the March low at Short-term Risk Factors: Will the UK economy endure a triple dip? It has been a major focal point for financial commentators in the UK in recent months, but we finally get to find out on Thursday whether or not the UK economy slipped back into recession for the third time. The consensus forecast is that we have just escaped with the economy expected to have expanded 0.1% in the first quarter of the year. Either way, the need to generate sustainable growth is top of the list of both the Bank of England and the Chancellor and thus we continue to feel that there is more scope for additional monetary easing in the months ahead. US economy expected to advance in Q1 The US economy is expected to have expanded 3% (on an annualised basis) in the first quarter of 2013, a significant jump from the 0.4% growth in Q A lower than expected reading will fuel expectations that the Fed will continue with QE3 for an extended period, thereby adding to the downward pressure on the dollar.

4 GBPEUR Key Influences Summary: Once again, sterling closed last week broadly unchanged against the euro. The pound initially came under pressure on Wednesday after weaker than expected UK employment figures, but this was countered by comments from ECB member Jens Weidmann, highlighting that the ECB could cut interest rates to boost the Eurozone economy. Key Influences: Fitch downgrades UK credit rating Last week ended with the announcement that a second rating agency, Fitch, has stripped the UK of its prized AAA credit rating citing weak growth and the disappointing results of austerity. One positive note [for George Osborne] was that the agency kept the outlook on its new rating as stable citing continued policy commitment to reducing the underlying budget deficit. UK expected to avoid triple dip recession The first estimate of Q1 GDP, due to be released on Thursday, is expected to show that the UK economy has narrowly avoided a triple dip. In the wake of last week s employment numbers for February/March, coupled with the release of March s retail sales figures, the consensus forecast is for GDP growth of 0.1% in the first quarter. Germany approves bailout package for Cyprus Having come under heavy pressure on Wednesday following Weidmann s comments, the euro recovered on Thursday on the announcement that German lawmakers voted by a big majority to back the bailout package for Cyprus as well as an extension to rescue loans for Portugal and Ireland. Key Levels: Support 1 Technical View: For the time being, GBP/EUR continues to consolidate within the broad trading range that has developed over the past two months, encouraging a neutral short-term bias. As previously highlighted, we continue to view this recent range as a period of consolidation within the longer term downward trend and thus envisage a retest of in the weeks and months ahead. From a technical perspective, a break back below 1.16 will be the first warning signal that such a move is likely to unfold. Short-term Risk Factors: German IFO Survey In the wake of a disappointing German ZEW survey last week showing a sharp fall in economic sentiment, the focus this week switches to the outlook for businesses in Europe s largest economy. The headline business sentiment survey is expected to fall marginally from to although a significantly weaker than expected reading will increase the pressure on the ECB to provide additional stimulus to boost confidence (by potentially cutting rates). UK Q1 GDP It has been a major focal point for financial commentators in the UK in recent months, but we finally get to find out on Thursday whether or not the UK economy has slipped back into recession for the third time. The consensus forecast is that we have just escaped with the economy expected to have expanded 0.1% in the first quarter of the year. Either way, the need to generate sustainable growth is top of the list of both the Bank of England and the Chancellor and thus we continue to feel that there is more scope for additional monetary easing in the months ahead Support RESISTANCE Resistance

EURUSD Key Influences Summary: After a quiet start to last week, the dollar came under heavy pressure on Tuesday after benign inflation data triggered speculation that the Fed will continue to flood

5 EURUSD Key Influences Summary: After a quiet start to last week, the dollar came under heavy pressure on Tuesday after benign inflation data triggered speculation that the Fed will continue to flood the market with cheap liquidity in an attempt to fuel the economic recovery. However, this was countered on Wednesday by comments from ECB member, Jens Weidmann, highlighting that there is still scope for the ECB to cut rates to help cushion the economic slowdown in Europe. Key Influences: US inflation remains subdued Headline CPI data showed that inflation continues to remain subdued (-0.2%m/m, 1.5%y/y). With this in mind, there remains little pressure on the Fed to scale back its ultra-loose monetary policy stance any time soon (something we highlighted in the Big Picture two weeks ago). ECB still has room to cut rates Although the ECB has been reluctant to be too aggressive with monetary policy (NB it doesn t have the same tools at its disposal as the BoE, BoJ or the Fed) ECB policy maker, Jens Weidmann offered a reminder that the ECB still has room to cut rates in the months ahead if the committee deems it necessary (European interest rates are currently 0.75% compared to 0.5% in the UK and 0.25% in the US). Germany approves bailout package for Cyprus Having come under heavy pressure on Wednesday following Weidmann s comments, the euro recovered on Thursday on the announcement that German lawmakers voted by a big majority to back the bailout package for Cyprus as well as an extension to rescue loans for Portugal and Ireland. Key Levels: Support 1 Technical View: With EUR/USD seemingly trapped between 1.30 and 1.32 (in the short term at least) there is little change to the overall outlook. As highlighted last week, support is expected at the psychological 1.30 level with a break here exposing the recent lows at again. However, in line with our fundamental outlook, we continue to favour the euro over the dollar in the months ahead and look for a break of to open up risk towards February s high of Short-term Risk Factors: US economy expected to advance in Q1 The US economy is expected to have expanded 3% (on an annualised basis) in the first quarter of 2013, a significant jump from the 0.4% growth in Q A lower than expected reading will fuel expectations that the Fed will continue with QE3 for an extended period, thereby adding to the downward pressure on the dollar. German IFO Survey In the wake of a disappointing German ZEW survey last week showing a sharp fall in economic sentiment, the focus this week switches to the outlook for businesses in Europe s largest economy. The headline business sentiment survey is expected to fall marginally from to although a significantly weaker than expected reading will increase the pressure on the ECB to provide additional stimulus to boost confidence (by potentially cutting rates) Support RESISTANCE Resistance

6 USDCAD Key Influences Summary: The Canadian dollar began last week under pressure against all its major counterparts as commodity prices continued their decline from the previous week. Having tested briefly below 1.01 two weeks ago, USD/CAD quickly recovered back towards 1.03 before closing the week at Key Influences: Bank of Canada votes to leave rates unchanged at 1% As widely expected, the Bank of Canada announced that it was keeping its key rate unchanged following Wednesday s meeting. Unsurprisingly, the Governor also lowered the Bank s estimate for economic growth this year to 1.5% from previous estimates of 1.8%. Previous expectations of a possible rate hike in 2013 have now completely diminished with the BoC now expected to keep rates at historically low levels well into Benign inflation reduces pressure for a rate hike Weaker than expected Canadian inflation data (released on Friday) supported the view that Canadian interest rates are likely to remain unchanged for an extended period. Throughout much of 2012, the risk of inflation was one of the key factors pointing towards a possible rate hike. However, with prices only increasing 1% compared to the same time last year, the BoC can afford to keep interest rates low to help generate sustainable growth. US inflation remains subdued The outlook for inflation is very similar across the border in the US where headline CPI data showed that inflation continues to remain subdued (-0.2%m/m, 1.5%y/y). With this in mind, there remains little pressure on the Fed to scale back its ultra-loose monetary policy stance any time soon (something we highlighted in the Big Picture two weeks ago). Key Levels: Support 1 Technical View: As highlighted on the chart above, USD/CAD looks to have broken the short term downward trend channel (highlighted in blue) thereby refocusing attention on the March high at While continues to contain rallies, broad risks continue to remain neutral (in the short term at least). In order to justify a more bullish outlook, we need to see USD/CAD sustain a move beyond , thereby exposing the 2012 high at However, a break below 1.01 should act as a warning signal for USD sellers as it will open up risk back to parity and the February low at before additional support is encountered. Short-term Risk Factors: Commodity prices remain under pressure The sharp decline in commodity prices over the past two weeks stabilised towards the end of last week. However, if this trend reasserts itself in the weeks ahead, the impact is likely to be felt in the currency markets, especially with regards to the Canadian dollar where the economy is so heavily dependent on its oil exports. Canadian Retail Sales Expectations of a possible rate hike in the months ahead have now been scaled right back, but data will be continually scrutinised to gauge whether or not additional stimulus is needed in the months ahead to prevent the Canadian economy from slipping into recession Support RESISTANCE Resistance

FX FORECASTS $ / / 3M 6M 1Y GBPUSD 1.48 1.45 1.50 Consensus 1.53 1.53 1.53 GBPEUR 1.14 1.10 1.07 Consensus 1.22 1.23 1.24 EURUSD 1.30 1.32 1.40 Consensus 1.32 1.31 1.29 USDCAD 1.05 1.00 0.

7 FX FORECASTS $ / / 3M 6M 1Y GBPUSD Consensus GBPEUR Consensus EURUSD Consensus USDCAD Consensus Consensus forecasts provided by the Consensus Economics monthly survey of 250 prominent currency forecasters. Validus forecasts are based on in-house analysis using technical, fundamental and market indicators.

8 ECONOMIC DATA & MARKET INDICATORS Economic Matrix GDP CPI Unemployment Industrial Retail Sales Current Account Budget Balance 10 Year Yield Production % GDP % GDP US 0.40% 1.50% 7.6% % +2.80% -2.99% -6.70% 1.728% EUR % 1.70% 12.0% -3.10% -1.40% +2.50% -4.40% 1.252% UK 0.20% 2.80% 7.9% % -0.80% -3.74% -6.35% 1.690% CAN % 1.00% 7.2% +1.04% -0.10% -3.84% -1.43% 1.710% Sentiment & Positioning Currency (vs. USD) Speculative Positioning 3 Month Trend Risk Reversals (1 Month, 25d) 3 Month Trend EUR -30K Neutral (EUR Negative) EUR Bearish UK -62K GBP Bearish (GBP Negative) GBP Bearish CAD -76K CAD Bearish (CAD Negative) CAD Bearish

9 WEEKLY ECONOMIC CALENDAR 22/04/ /04/ /04/ /04/ /04/2013 Location Time Indicator For Previous Forecast US 3.00pm Existing Home Sales Mar 4.98m 5.00m EZ 3.00pm Consumer Confidence Apr EZ 9.00am Manufacturing PMI (final) Apr EZ 9.00am Services PMI (final) Apr UK 9.30am Public Sector Net Borrowing Mar 4.4bn 13.8bn UK 11.00am CBI Industrial Trends Survey Apr CA 1.30pm Retail Sales (m/m) Feb 1.0% 0.3% US 3.00pm New Home Sales Mar 411k 418k EZ 9.00am German IFO Survey Apr UK 11.00am CBI Retail Sales Apr 0 8 US 1.30pm Durable Goods Orders Mar 5.7% -3.0% UK 9.30am GDP First Estimate (q/q) Q1-0.3% 0.1% UK 9.30am GDP First Estimate (y/y) Q1 0.2% 0.4% US 1.30pm Initial Jobless Claims (w/e 20 th Apr) 352k 354k US 1.30pm GDP First Reading (q/q - annualised) Q1 0.4% 3.0% US 2.55pm University of Michigan Sentiment Survey Apr Country Current Rate Last Change Date of Change Next Meeting UK 0.50% -0.50% 5 th Mar 09 9 th May 13 US % -0.75% 16 th Dec 09 1 st May 13 CAN 1.00% +0.25% 8 th Dec th May 13 EUR 0.75% -0.25% 5 th July 12 2 nd May 13

bias for the dollar in the months ahead.

bias for the dollar in the months ahead. WHAT ARE THE CHANCES Risk Insight Volume 6, Issue 10-16 March 2015..that EURUSD will touch 1.0 within the next 3 months? 31.0% The Big Picture FOMC meeting shaping the direction of the currency markets