Inflation is climbing and, with it, the pressure on central banks to raise rates. The BoE are likely to tighten first, followed by the ECB. The inflation is cost-push, arising from increases in the prices of crude, foodstuffs, steel, and the like. It is strange that the USA is not seeing similar inflationary pressure, especially as the USD has weakened so much, but that may just be a matter of time, as the steepening of the USD yield curve suggests.
Higher interest rates are the last thing that governments want while recovery is so fragile. That would suggest a certain tension between European governments and their central banks. Although governments can scarcely admit it, higher inflation does of course carry with it the attraction of reducing debt to GDP ratios. Pay lip service to the official target rate of 2%, but do not insist too much!
If there is a struggle between central banks and governments, it may be resolved by bond markets. They are pushing up longer-term yields, and there will come a point when anchoring overnight rates so low may help increase bank profits, but does little for the rest of the economy. Overall, we expect the BoE to raise its rates sooner rather than later. The ECB will wait as long as possible in the hope that the menace of inflation will dissipate. We do not think it will, and believe that they will have to act within 2011.
When will the USA be forced to face the same issues? Not for as long as the Federal Government can borrow so cheaply. It will take quite severe yield curve steepening before action is forced upon it to be much more serious about rebalancing the Federal budget. Let us however admit that whenever we have thought that the USA must now reverse its path of spending beyond its means, it manages to put off the inevitable still further.
A significant development in 2010, which is becoming even more evident in early 2011, is the growing importance of Chinas role in financial markets. We have already seen their contribution to the rescue of the EUR, and it is now lending more to emerging markets than even the World Bank. It has allowed a timid role for the RMB in international trade within Asia. However, the most important news is President Hus announcement that the RMB will gradually take on the role of a reserve currency. As we have been proposing for many years, full global rebalancing needs three major zones, the US, Europe and Asia, each with its own leading reserve and trading currency.
Risk appetite in fixed income markets is high, especially in USD. We would question the risk/reward characteristics of low-credit corporates, but believe that sovereign debt in Europe may be closer to a fair price. We note that some utilities in peripheral countries are offering attractive bonds.
January 19th 2011
Dr. Roy Damary