Macro Weekly – No panic, please

by: Han de Jong

  • Talk of quantitative tightening misses the point
  • No fundamental justification for materially higher bond yields
  • Eurozone growth gaining further momentum
  • US inflation neither a victory for optimists nor for pessimists
  • Chinese import growth sharply lower, but no cause for concern
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Recent days have seen the focus shifting to the bond markets. Is the 30-year bull run in bonds ending and, more importantly, reversing? Are central banks engaging in quantitative tightening, or if you prefer, are they reversing their QE measures? Are the Chinese going to sell their Treasuries and are the Japanese buying fewer Treasuries? Is the ECB changing direction sooner than expected?

This sort of questions was at the minds of investors in recent days. The result has been that Bund yields have risen more than 10 basis points in a week with the yield flirting with the highest level of the last two years. US Treasury yields have also risen and are also flirting with their highest level of the last two years. Some even argue that Treasury yields are threatening to break out of their 30-year old trend decline. Should bond yields in these markets, indeed, rise and rise materially, this would upset many other financial markets and potentially a great deal. The euro, meanwhile, has reached its highest level against the US dollar since late 2014.

Markets can be driven by a range of factors: sentiment, technicals, flows and fundamentals are the most obvious. As an economist, I follow fundamentals, that is my thing. But having been round the block a few times, I realise that fundamentals may be outvoted at times by other drivers. So, I would say it is entirely possible that recent market moves will persist for a while. The question I want to answer is if a continuation of these moves is justified by fundamentals. If they are not, I think they will come to a halt at some stage and possibly be reversed.

As far as these fundamentals are concerned, the two things to focus on are central bank policy and inflation.

Central banks will cherish their success

I think recent excitement about central banks reversing policy is completely exaggerated. Yes, the tone of the ECB was more hawkish than before. But that does not mean they will change policy dramatically. Economic growth was well in excess of expectations in 2017 and growth momentum continues to strengthen. How do you expect the ECB to react to that? Inflation is still below target, but risks of painful deflation have eased or even disappeared. The ECB has put its cards for this year on the table. It is actually a sign of remarkable restraint that even the hawks seem to agree that it would be unwise to stop the purchasing programme earlier than announced. What happens after September is obviously open for discussion.

Don’t believe all rumours

The excitement about the Chinese stopping to buy US Treasuries and the Bank of Japan buying fewer as they are allegedly exiting from their QE is also totally exaggerated in our view. Even if the Chinese would be considering holding fewer US Treasuries, they would make certain nobody knew about it beforehand as they would only ruin the market for themselves. In fact, particularly if they were in fact planning to reduce their Treasury holdings they would not let anybody else know and keep their cards close to their chest. And the Japanese are traumatised by earlier experiences when they reversed policy only to be kicked back in trouble before too long. I cannot imagine they would now want to change direction soon or fast.

The funniest in this debate is the Fed. They started reducing the length of their balance sheet in October, so this exercise has been going on for three months, but nobody is talking about it. Their target initially is to reduce their asset holdings by USD 10 bn a month. That is not much, but it will increase. The Fed wants to do this as predictably as possible in order not to upset anyone. Indeed, not only aren’t they upsetting anybody, hardly anybody seems to be taking notice.

The bottom line with the central banks are proud of what they are, rightly or wrongly, convinced they have achieved: they have prevented depression and engineered an impressive recovery. They certainly do not want to risk snatching defeat from the jaws of victory.

Disinflationary forces will prevent material pick up of inflation

Inflation will also play a key role in what happens to interest rates and bond yields in 2018. This applies in particular to US inflation as the US economy (and its central bank) is furthest advanced in the business cycle. Much to the surprise of virtually everybody, US core inflation eased in 2017. Fed chair Yellen called it a ‘mystery’. We were on the right side of consensus last year and we believe that it really isn’t a great mystery why underlying inflation moved down. Unit wage cost increases fell in 2017 and wages are a key driver of inflation. Wage increases were surprisingly modest given the tightness of the labour market, that was perhaps a bit of a mystery, but more important, productivity increases accelerated. We expect this pattern to continue this year. As we have argued before here, US inflation may well rise somewhat this year as the labour market is increasingly tight and higher oil prices make themselves felt. However, the point is that any rise will be modest.

On balance therefore, we think that neither central bank action nor inflation should justify materially higher bond yields. Should technicals or sentiment push yields in the US or the eurozone out of their trading range of the last two years, then technically, the way is open to a big rise. But fundamentally there is no real justification for it. We would therefore think any such rise will prove temporary.

Europe’s momentum relentless

Recent trading days have seen a further set of impressive data in the eurozone. The European Commission Index of Economic Sentiment rose further in December: 116.0 against 114.6 in November. I had already been so surprised that it had risen in November. The index is it at its highest level since 2000. Apart from 2000 there is no period on record with stronger readings than the current one. The European Commission’s Business Climate indicator also rose and reached its highest level as far as my Bloomberg allows me to look back, which is 1985. Unsurprisingly, business confidence in France rose strongly in December. Harder data in Germany was strong, but more mixed in France. German factory orders fell 0.4% mom in November, but the yoy rate amounted to 8.7%, versus 7.2% in October. Industrial production was up a solid 5.6% yoy in November.


US inflation neither here nor there

US headline inflation amounted to 0.1% mom in December as core CPI advanced 0.3%. The yoy numbers were 2.1% for headline, against 2.2% in November, and 1.8% for core, against 1.7% in November. The verdict one would have to attach to this report is ‘undecided’. This report does not suggest that inflation is picking up, but neither that inflation cannot pick up in the months ahead. Given how strong the global economy is, I think US inflation remains remarkably low, reflecting solid disinflationary structural forces.

Retail sales were up 0.4% mom in December, after an upwardly revised 0.9%. This was another healthy number. There is every chance that the US data over January will be significantly distorted. The severe winter along the east coast and in the mid-west will have an effect as will the mud slides in California. This will make it more difficult to read the tea leaves of the US economy.

Chinese imports and Taiwanese exports do not add up

Chinese trade data over December were released recently. I think they need to be monitored as stronger than expected Chinese growth was important to the global economy last year. And the way for the rest of the world to feel the effects of China is trade. Chinese exports (in USD) were up 10.9% yoy in December. That was OK, the November number had been 11.5%. But import growth decelerated sharply, from 17.6% to 4.5%. Of course, trade data can be volatile from month to month, so no reason to get overly concerned. Indeed, perhaps one should average November and December: 11.0%. It can also be helpful at the trade stats of neighbouring countries. The Chinese market is the biggest export market for Taiwanese producers. Taiwanese exports did not slow at all in December: 14.8% yoy, versus 14.0% in November. Normally, the trend in Taiwan’s export mirrors the overall trend of China’s imports. So while this data bears watching for anybody who wants to keep an eye on the global business cycle, the December Chinese trade data is not a cause for concern.