Inflation.....and bond yields!

Following last week’s inflation report from The Bank of England this week’s actual inflation report for July came in much as expected with the headline CPI dropping to 3.1% Y/Y from 3.2% in June.

Because of my recent foray into the media about inflation and the economy I have been paying closer attention to UK inflation and the underlying factors driving it. What no-one seems to notice, or care about, except for the B of E is that CPIY i.e. inflation without indirect taxes and in particular without VAT fell from 1.6% Y/Y to 1.4%. 

This is the measure  we should focus on as the VAT decrease in 2009 followed by the increase in 2010, which will be followed by anther increase in 2011 will make it impossible for anyone to deduct anything from the headline CPI number - anyone who says differently is either stupid or lying, or both! 

This was also the case in 2009 when CPI was much lower than CPI-Y as the effect of the temporary VAT reduction fed through to CPI. What is more interesting is that CPI-Y has continued to fall from the peak of just over 5% in 2008 to the current level of 1.4%, albeit not in a straight line, the trend is clear......lower! 

Even the inflationists favorite measure the RPI, when stripping out the VAT effects etc and looking at the RPIY fell from 3.8% Y/Y to 3.5%.

Elsewhere it is deflation that's staring policy makers in the face - The Fed is clearly worried and it probably won't be long before QE2 light will be replaced by a fully fledged version somewhere between $500 billion and $1 trillion. Philly Fed's survey which was released yesterday at -7 instead of the expected +7 and weekly jobless claims topping 500k again.  

Recovery? Has it been and gone already?

In the bond markets yields are reflecting the very weak economic backdrop (even if the equity market participants are not fully embracing this reality) and with US mortgage yields in deep re-financing territory (all the ones who can will refinance) the negative convexity is playing havoc with duration i.e. If you need/want duration the only place to go really is the back end of the yield curve, which is why it’s starting to flatten smartly and will probably continue to do so as 2 year yields below 50 bp’s hardly provides any protection or yield, 30 years at 3.60-something is the place to be. 10-30’s is still north of 100 bp’s and that could easily come back into the 50-75 bp range during the remainder of this year. It could go even lower depending on the launch of the new QE2 and the scope/weighting of it.

All the bond-bubble alarmists will be hurting emotionally (financially as well if they put their money where there mouths are) as the market will continue to rally and the curve continues to flatten......but the more of them there are the better for the market’s prospects as short covering is a very powerful thing.....! 

If you care for a more thorough trashing of the latest bond-bubble alarmists' arguments then you should read David Rosenberg's daily comment from yesterday.....it's very good reading indeed!

Interesting day....

Having spent the morning appearing on no less then three BBC radio programmes including the Today program as well as the BBC Business Report on BBC World, it has given me  a reminder of how little time general news actually gives to financial/business news.

Trying to debate the Fed’s actions last night  and the implications of QE, the prospects for growth and inflation globally and specifically in the UK in slots of 3 mins or less is very difficult and the generalizations become huge!

So what do I think? The Fed’s announcement that they would keep the balance sheet at current levels by re-investing mortgage backed coupons and redemptions in treasuries is, I’m sure better than not doing it, but is it just rearranging the deck chairs on the Titanic? It could well be, as the base case looks more and more like a double-dip - I out the odds at 50/50 this morning, but even if we don’t technically get a double-dip growth will be very sluggish for a long time.

I did a little digging on UK inflation data last night in preparation of my media appearances this morning and found that CPI-Y (that is CPI without indirect taxes such as VAT) is actually quite stable and currently running at 1.6% Y/Y, which is what the Bank of England should be focusing on when they talk to the markets and the media. Their mandate may be headline CPI, but they cannot be held responsible for, or even asked to take this into account when it is the government that is responsible for half the current annual growth in CPI i.e. taxes.

While the MPC always say they are looking ‘through’ the temporary effects of indirect taxation and the effective depreciation of sterling, why don’t they start talking about the CPI-Y, or the net-price index as I would call it ?????

Well, they can of course start that today at the press conference and if they do I will be taking all the credit!

I had the pleasure of meeting Andrew Lilico from the Policy Exchange before and after our debate on the Today program and while he thinks the economy will be weak in the short term and that more QE is forthcoming as well, but then our views are very different as Andrew believes that growth in the second half of 2011 will take off sharply and inflation will follow. I completely disagree as I see no growth of any significance in a scenario where the government is cutting expenditure aggressively and the banking system is still broken and the shadow banking system has ceased to exist. There can be no growth without access to credit, unless it’s government sponsored.

Bond markets seem to be continuing to take the cue and rally to this new economic reality, but equity markets are completely mis-priced, why on earth they think that corporate profitability can continue to grow in a no-, or low growth economy is beyond me. There are only so many costs and jobs that can be cut - and while these cost saving measures may be good for an individual company’s short-term profitability, they are terrible for the economy as a whole. The difference is that bond markets can be a leading indicator, while the equity market is clueless........!