APRIL 8, 11 Bond market: Inflation and yield forecasts raised The European Central Bank has raised its key interest rate on Thursday by basis points to 1.%. The market expected this rate step, as the central bankers had already ratcheted up anti-inflation rhetoric significantly at their last meeting. At a press conference on March, ECB President Trichet said that inflation was being watched with strong vigilance, and he no longer described the current policy interest rate as appropriate. In the past, that has always been a signal that the ECB would raise rates at its next meeting. % % 1% -1% Jan 9 Jan 9 Jan 96 E-16: Inflation and core inflation rate Inflation rate Core inflation rate felt inflation (Index; r.h.s.) The development of prices is likely to have given the central bankers cause for concern. The inflation rate rose above the level regarded by the ECB as critical already in December 1. Prices have continued to climb unabated since then, and the inflation rate in the euro area rose to.6% in March., 1,% 1,,%, -,% -1, -1,% Jan 97 Share of different goods in the European rate of inflation Jan 99 Jan 1 Jan Jan Jan 7 Jan 9 Food Industrial goods Energy Services Jan 11 6 1-1 - In particular, goods often bought by consumers have become more expensive. Food, for example, cost.% more in March than it did a year earlier, and energy prices were up by 1.1%. Although the shares of these categories in the basket of goods are not especially high (food 19.% and energy 1.%), the price upsurge in these areas has contributed substantially to the increase of the inflation rate. Higher energy prices compared with a year ago are alone responsible for 1. percentage points of the headline inflation rate in March. Although the services sector made the second-largest contribution, which came to.7 percentage points, rising prices for services usually contribute more strongly to consumer price increases. The share of food in the headline inflation rate has climbed back to its historical contribution level of. percentage points, and the upward trend of food prices is likely to continue. At., the inflation rate in the United States is somewhat lower than its European counterpart, but the speed at which the rate has increased lately has surprised many analysts. As in Europe, food and energy prices have been the main contributors to the rise of prices. However, unlike in Europe, the Fed has so far not reacted by turning away from its ultra-expansionary monetary policy. Within the Federal Open Market Committee (FOMC), the body that makes the policy interest rate decisions in the United States, some central bankers known as monetary policy hawks have recently argued for at least allowing the continuing program of purchasing government bonds to expire early. But there is not even a majority in favor of that within the Fed yet. The Fed s much less cautious approach to fighting inflation is attributable to two factors. Unlike the ECB, the US central bank assigns greater significance to the core rate when judging consumer prices. The core rate, which does not include volatile food and commodity prices, has so far not increased very sharply either in Europe (1.) or in the United States (.9%). Moreover, unlike the ECB, the Fed is not solely dedicated to price stability, but is also supposed to achieve a high level of employment with its monetary policy. Despite the unemployment rate s recent drop to 8.8%, this goal cannot be considered accomplished from the Fed s standpoint. In our opinion, however, the topic of inflation will probably gain in importance on both sides of the Atlantic. For, almost all indications are that inflation will increase further in the coming months. Thus, import and producer prices, which run ahead of consumer prices, have already risen sharply. In Europe, import prices climbed year on year by 1 in December 1, their strongest increase since autumn 1981. The increase of prices slowed somewhat in the first two months of 11 compared with December, but remained at a very high level significantly above 11%. A similar picture emerges for producer prices. Moreover, the components in producer prices show that the increase is no longer limited to food and commodity prices, and core rates have also risen year on year. That is shown, for example, by US Labor Department data for February. In the United States, the rise of prices of intermediate goods in the core rate amounted to. (in contrast to a general increase across all intermediates by 7.8%). The core rate of producer prices climbed more moderately on the preceding year, but the figures here also show that the rise of prices can no longer be attributed solely to higher-priced food and energy. The figures from Europe confirm that. In February, producer prices were up by 6.6% on the preceding year, 1
and the increase in the core rate (ex energy and food) amounted to.%. 1 Growth rates of broader monetary aggegates (y/y) 1 9 6 1 Apr- Oct- Apr- Oct- USA: Inflation and PMI-price-component Apr- Oct- Apr- Oct- Apr-6 Oct-6 Apr-7 Oct-7 Apr-8 Oct-8 Apr-9 Oct-9 Apr-1 Oct-1 Apr-11 6% % % 1% -1% - 1 1 8% 6% - - Dec-89 Dec-91 Dec-9 Dec-9 Dec-97 Dec-99 Euroland M Dec-1 Dec- USA M Dec- Dec-7 Dec-9 Dec-11 ISM manufacturing ISM services PMI Chicago CPI (y/y, r.h.s.) Surveys of businesses likewise reveal that prices of raw materials and intermediate goods are on the rise. We consider this a comparatively reliable leading indicator for consumer prices, since the good economic situation is likely to enable businesses to pass on at least some of the price increase to consumers in the coming months. In view of the current data from purchasing managers regarding input prices, consumer prices would have to be increasing now by about based on historical experience in the United States and thus by significantly more than the current inflation rate of.. The corresponding historical data for Europe are not available, but the situation of European businesses is not likely to be much different from that of their US counterparts. Despite all the signs that argue for an increase of consumer prices in the coming months, two important factors remain that are likely to prevent a worrisome rise of the inflation rate for the time being. First, the situation on the labor market remains so slack on both sides of the Atlantic that latitude for wage increases will remain generally limited. Certainly, higher collective bargaining agreements will be reached in some cases, e.g., in Germany. However, since collective bargaining agreements usually run for up to two years, it is likely to take some time before wage increases in fact broadly reflect the stronger inflation and positive economic situation. In other euro countries and the United States, by contrast, latitude for wage increases will remain limited in the foreseeable future. And against the background of the strained budget situation, pension and unemployment benefits will probably also not increase inordinately. Consequently, second-round effects, of which the central bank takes an especially critical view, will remain limited, and there is no threat of a wage-price spiral with mutually reinforcing effects either today or in the next 1-18 months, a relatively visible time frame for us. Second, the monetary trend is exerting just as little pressure on prices as the labor market. The money supply aggregates relevant for the real economy, M in Europe and M in the United States, are still growing below average. The higher growth compared with the previous months is almost solely due to base effects and not to actual money supply expansion. Unlike the labor market, however, money and credit supply development remains a factor on which one must keep an eye. For, in some parts of Europe and in the United States, fundamental conditions have become so attractive for businesses that they are increasingly financing new capital investments and could give a boost to the lending process. However, in view of the private sector s still high debt level in the United States and the slack labor market in Europe, total household demand for credit is not likely to expand substantially. We therefore expect that the credit supply will grow in the coming months, but the prerequisites are still lacking for an above-average increase of the credit and money supply. To get an impression of how inflation rates will develop in the course of the year, we have assumed for the coming months that prices are developing at about the historical average, an assumption that has also proved accurate in the past months. On this assumption, the inflation rate in the euro area will continue to rise until mid-year and just exceed the % mark in the summer months. However, it is then likely slow to.% by year s end due to base effects. Based on the new estimates for the euro area, we are raising our forecast of average annual inflation from. to.7%. In the United States, the inflation rate is likely to increase more on annual average than in Europe; we expect an inflation rate of.8% on average (previously.1%). Inflation could reach its peak in autumn, and we expect a return to lower inflation rates then in the winter months. Forecast uncertainties exist particularly in respect to the further development of oil prices. If the uncertainties in the Middle East and North Africa should increase further, then our estimates might prove to be too conservative. However, we do not consider it out of the question that the situation there will stabilize. Since the oil price currently contains a considerable risk premium, in our opinion, lower inflation rates would then also be possible.
The central banks have probably closely observed that inflation expectations on the capital markets have already increased. Implicit inflation rates derived from inflationprotected bonds are a much-heeded indicator for that. The implicit inflation rate is calculated from the price difference between inflation-indexed and conventional government bonds, and it shows what average inflation rate is expected over the residual maturity of the bonds. In the chart, the expectations are calculated on the basis of bonds with a 7-year residual maturity in Europe and a 1-year residual maturity in the United States. For the United States, market participants expect an inflation rate of just under % on average in the coming 1 years; expectations in Europe currently stand at.6%.,,,, 1, 1,,, -, -1, USA and Euroland: Implicit inflation expectations of inflationbacked bonds Jan 99 Jan 1 Jan Jan Jan 7 Jan 9 Jan 11 during 11, as we expect, the euro area is likely to grow in real terms by.. In nominal terms, growth is thus likely to be about.%, in line with our inflation forecast. Even if the ECB does not strive for complete normalization of monetary policy in the coming year, considerable maneuvering room remains against this background to increase key interest rates further in 1. We therefore regard a key interest rate of. by the end of 1 as likely. In the United States, we believe the Fed is likely to raise its policy interest rate by basis points already this year. On the one hand, we expect it will underestimate the momentum of inflation, and a further rise of inflation expectations would not serve its purposes for the reasons described above. On the other hand, we have already pointed out several times that the US economic recovery is likely to contribute increasingly to improvement of labor market conditions. We expect the Fed will ratchet up its rhetoric at the latest when employment growth in the United States has been at more than, jobs for several months. 6 Europe: Euribor-Futures and 1-year Bunds yield,, Euroland USA Surveys of consumers suggest that they expect even much sharper price increases. In the United States, consumers expect an inflation rate of.6% to 6.7% in the next 1 months, depending on the survey considered. The survey results themselves have almost no value for forecasting inflation in 1 months, but it is in the Fed s interest not to allow inflation expectations to get out of hand. For, if the fear of money devaluation rises, that may cause labor negotiations to be conducted more aggressively, interest rates to rise especially for loans and long bonds, and prices for goods and services to be increased proactively, with the result that the inflation expectations become a self-fulfilling prophecy. We therefore expect the ECB to raise its key interest rate in two steps, by bp each, to 1.7% by the end of the year. Further rate hikes could follow, particularly with a view to 1. As a rule of thumb, a key interest rate equal to the nominal growth rate has a neutral effect on the economic cycle. If the economic trend in Europe stabilizes further 1 Dec-7 Mar-8 Jun-8 Sep-8 Dec-8 Mar-9 Jun-9 Sep-9 December 11 December 1 1 Y Bunds (r.h.s.) With higher key interest rates in Europe and in the United States and increasingly with a view to 1, we have raised our yield forecasts for 1-year Bunds from.6% to.7%. At a yield on 1-year Bunds now of.6%, investors face the prospect of further price losses in the next 1 months, but they will probably not entirely consume the coupon. Against this background, the duration of bond portfolios should remain short. In view of the better opportunity-risk ratio of stocks, we believe that investors have more promising prospects with a higher weighting of stocks versus bonds. Dec-9 Mar-1 Jun-1 Sep-1 Dec-1 Mar-11 Jun-11,
Weekly outlook for the period of April 11-1, 11 Nov. Dec. Jan. Feb. Mar. Apr. Release DE: Consumer prices, m/m.1% 1. -..%.% April 1 DE: Consumer prices, y/y 1.% 1.7%..1%.1% April 1 DE: ZEW economic expectations 1.8. 1. 1.7 1.1 1.7 April 1 EUR17: Industrial production, m/m 1. -.1%.%.6% April 1 EUR17: Industrial production, y/y 7.7% 8. 6.6% 7.7% April 1 EUR17: Headline inflation rate, m/m.1%.6% -.7%.. April 1 EUR17: Headline inflation rate, y/y 1.9%..%..6% April 1 EUR17: Core inflation rate, m/m.. -1.%..8% April 1 EUR17: Core inflation rate, y/y 1. 1.1% 1. 1. 1. April 1 MMWB estimates in red. Chart of the week: German companies order more capital goods 1-1 - Germany: New orders for capital goods and capacity utilization 9 88 86 8 8 78 76 7 7 - Feb. 9 Feb. 9 Feb. 96 Feb. 98 Feb. Feb. Feb. Feb. 6 Feb. 8 Feb. 1 Capital spending (y/y) New orders for capital goods (domestic; y/y) Capacity utilization (r.h.s) The order situation of German companies improved in February to a surprisingly extent. After an increase in orders of.1% in January (versus the preceding month), companies registered another plus of.1% in February. It is particularly good news that demand for capital goods from German customers rose for the second time in a row, and the increase compared with the preceding year amounted to.9%. Demand for capital goods is one of the best leading indicators for equipment spending. We have heretofore expected that capital spending might increase by 1 this year. If the positive trend in orders for capital goods should continue, we see potential for upward revision of our estimates to 1%. There is also further upward potential for capacity utilization, which is already above its long-term average of about 8%. The very positive order intake and good production data released today show that the German economy should grow strongly in 11. Against this background, we are reaffirming our growth forecast of.1%. M.M.WARBURG INVESTMENT RESEARCH
As of Change versus 7..11 1..11 7..11 7.1.11 1.1.1 Stock markets -1 week -1 month - months YTD Dow Jones 1.9,%,6% 6,% 7, S&P 1.,1% 1,8%,9% 6, Nasdaq.796, 1,8%,, Wilshire 1.11,1%,, 6,% DAX 7.179,,,%,8% MDAX 1.88,,,1%,6% TecDAX 97 -,1%,6% 7,8% 1, EuroStoxx.96, 1,1%,% 6,1% Stoxx.69,6% -, -,1%, Nikkei 9.91-1, -8,7% -9, -6, Topix 81 -,% -1,7% -9, -6, Bond markets months Euribor 1,8 11 8 7 months Treasury Bill, - -7-1 -8 1 year US Treasuries,6 11 6 1 year Bunds, 1 1 year JGB 1,1 6 11 19 US mortgage rate,86-1 9 IBOXX AAA,,1 1 9 IBOXX BBB,,6-7 - 1 1 ML US High Yield 7, -8 - -6 - JPM EMBI+, Index 7,,9%,% 1,1% Convertible Bonds, Exane.1, -,1% 1,6%,7% Commodities CRB Index 679,7,9% -,% 1, 7,9% MG Base Metal Index 6,61,%,%,9%,8% Crude oil Brent 1,78, 6, 8,8% 1,% Gold 17,9,% 1,6%,9%,8% Freight rates Baltic Dry Index 1.1-7,8% 1, -7,8% -1, Currencies Financial markets at a glance EUR/ USD 1,8 1, 1,8% 1, 6,9% EUR/ GBP,8761 -,7% 1,%,1%, EUR/ JPY 11,,6%,7% 1, 1, EUR/ CHF 1,118,% 1,,8%,9% USD/JPY 8,96 1,1%,%,%,7% Carsten Klude Dr. Christian Jasperneite Matthias Thiel +9 8-7 +9 8-9 +9 8-1 cklude@mmwarburg.com cjasperneite@mmwarburg.com mthiel@mmwarburg.com The reports, tables, and charts presented are based on reliable information from publicly accessible sources. We, however, make no guarantee of accuracy. The content is protected by copyright. M.M.WARBURG INVESTMENT RESEARCH