UK Inflation Watch: 10-Year Gilt Yield vs. GBP/USD and FTSE 250 - Distressed Volatility


Wednesday, February 20, 2013

UK Inflation Watch: 10-Year Gilt Yield vs. GBP/USD and FTSE 250

Markets in the UK have made interesting moves recently. The UK 10-year Gilt yield (dark orange) broke above 2% on January 3, 2013 (now at 2.18%), the FTSE 250 Index (green) broke above 12,000 on 11/29/2012 (now at 13,654), and GBP/USD fell from 1.65 to 1.545 (failed to breakout of a double top).


So what are these moves saying. Is inflation going to be a problem going forward in the UK? Stagflation? The UK's annual CPI was at 2.7% in January 2013, unchanged since October 2012.


Here's what Governor Mervyn King said at the Bank of England's Inflation Report Press Conference on February 13, 2013:

"Inflation has remained stubbornly above the 2% target, and was unchanged in January at 2.7%. Increases in university tuition fees and domestic energy bills, largely resulting from administrative decisions rather than market forces, have added to inflation recently. These and other administered and regulated prices contributed around 1 percentage point to inflation at the end of last year, more than double the historical average. They are likely to push up on inflation over much of the forecast period, making the challenge of bringing inflation back to 2% more difficult."

"Inflation is likely to rise further in the near term and may remain above the 2% target for the next two years, reflecting sterling’s recent depreciation and the persistent contribution from administered and regulated prices. That persistent contribution is increasingly offset by a gentle moderation in domestic cost growth, and an easing in external price pressures, such that inflation is likely to fall back to around the target by the end of the forecast period. The outlook for inflation over much of the forecast period is higher than in the November Report, reflecting the impacts of administered prices and the lower exchange rate.

You might be tempted to think that an above-target inflation forecast justifies a tighter monetary policy. Certainly, ensuring that inflation returns to target in the medium term is our primary responsibility and objective. But the MPC’s remit is to deliver price stability in the medium term in a way that avoids undesirable volatility in output in the short run. The prospect of a further prolonged period of above-target inflation must therefore be considered alongside the weakness of the real economy. Attempting to bring inflation back to target sooner would risk derailing the recovery and undershooting the target in the medium term. So long as domestic cost and price 3 pressures remain subdued, we will continue to look through the temporary, albeit protracted, period of above-target inflation in order to support the recovery in growth and employment.

That policy stance is already exceptionally supportive of output. Interest rates are close to zero and the Bank’s balance sheet has expanded by a factor of five since before the financial crisis. Expressed as a share of GDP, the increase in our balance sheet since 2007 is greater than that in the United States, Japan or the euro area. But, if necessary, we will do more. At its meeting last week, the Committee agreed that it stood ready to provide additional monetary stimulus if warranted by the outlook for growth and inflation."

So there's your answer. Also, Bank of Canada Governor Mark Carney is set to take over as Governor of the Bank of England on June 1, 2013. According to Bloomberg News, he "discussed the merits of targeting a level of nominal gross domestic product". Wow (see more articles below.) Like the Federal Reserve, the Bank of England has been buying up bonds to lower interest rates and boost stock prices (risk assets).

Here are quotes from the Bank of England's most recent monetary policy statement on February 7, 2013:

"The Bank of England’s Monetary Policy Committee today voted to maintain the official Bank Rate paid on commercial bank reserves at 0.5%. The Committee also voted to maintain the stock of asset purchases financed by the issuance of central bank reserves at £375 billion.

Over the past year, there has been considerable volatility in quarterly output growth. Looking through the influence of temporary factors, overall output appears to have been broadly flat. In large part that reflects sharp falls in particular sectors of the economy that are unlikely to be repeated in 2013. In contrast, the combined output of the manufacturing and services sectors has grown modestly. Business surveys suggest the pace of expansion is likely to remain muted in the near term. The weakness in overall output sits in sharp contrast to continued strong employment growth, suggesting that the financial crisis may have had some impact on the effective supply capacity of the economy.

The MPC continues to judge that the UK economy is set for a slow but sustained recovery in both demand and effective supply, aided by a further easing in credit conditions – supported by the Bank’s programme of asset purchases and the Funding for Lending Scheme – and some improvement in the global environment. But the risks are weighted to the downside, not least because of the challenges facing the euro area. "

So will the perfect equilibrium between low economic growth, deleveraging, low inflation, quantitative easing, and currency wars last forever?

I want to know more about this chart released by Citi's Matt King a few months ago (via Business Insider). It shows real house price indices versus the inverse dependency ratio going forward ("the proportion of population of working age relative to old and young") for the UK, U.S., Spain, Australia, Japan, and Ireland. Real house prices follow the inverse dependency ratio (see Japan's chart), and it looks like the UK's inverse dependency ratio crashes going into 2030. According to his charts, real house prices in Spain, Australia and the U.S. could see more downside ahead. (Correction: Added "inverse" to dependency ratio.)

Source: Citi via Business Insider

So it will be demographic trends vs. central banks and currency wars going forward.

George Soros Is Going After The Two Most Hated Currencies In The World (Yen and Pound) (Business Insider)
Funds target sterling in Carney ‘short’ (Financial Times)
Sterling: Turning Japanese (EuroMoney)
Is there a global currency war? ‘Indeed,’ says David Rosenberg (The Globe and Mail)
Fund managers split on UK inflation outlook (MoneyMarketing)
Sir Mervyn King says abandoning inflation target would be 'irresponsible' (The Telegraph)

Watch 1.523 support on GBP/USD's chart. I'll chart out every GBP pair soon. They all look interesting.

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