Do they finally get it?

The much feared Portuguese auction went well earlier today with the Treasury being able to place EUR1.25bn of 4y and 10y bonds, the high end of the intended 0.75bn-1.25bn range. The main reason for this outcome should be seen in the significant buying of peripheral bonds by the ECB earlier this week. This put the dealer community short in peripheral debt including Portugal and thereby provided much support for today's auction. Furthermore, it saw peripheral bond spreads tighten sharply over the past days. This shows that ECB bond buying can have a significant impact on market dynamics. If the ECB effectively provides a cap on peripheral bond yields, then it can a) also draw back private investors into the market again as it reduces near-term potential mark-to-market losses whereas the carry available through the high bond spreads renders investments attractive again, b) change the underlying debt dynamics of the peripheral countries (c.p. lower yields mean that deficits are being reduced) and c) lead to a less restrictive monetary environment for the countries in question which supports growth. Additionally, each of these effects is reinforcing each other and therefore significant ECB buying has the potential to establish a positive feedback loop (Establishing such a positive feedback loop via a significant bond buying programme is what I suggested the ECB should do in Monetary easing in the wrong places or will the real ECB please stand up dated November 17). This would just be the opposite of the dynamic which has been at work so far where higher yields work to worsen deficits, reduce growth and deter investors, resulting in higher yields again.
Furthermore, proposals to increase the size of the EFSF and to broaden its mandate which would include buying of government bonds in the secondary market have been doing the rounds. This could even result in an improvement over a bond-buying programme by the ECB as it prevents the ECB from becoming too much involved in political issues. Furthermore, it would allow the ECB to continue concentrating on its main policy instruments (the setting of the short-term repo rate and the provision of liquidity).

Bolder ECB action causes significant yield drop in peripheral bonds (10y benchmarks)

Source: Bloomberg

I am convinced that bold and sustained action by the ECB (or potentially the EFSF) can establish a positive feedback loop which would result in a fundamental change in the dynamic of Eurozone government bond markets. It would go hand in hand with an aggressive and lasting tightening of peripheral government bond spreads as well as the pricing of an upcoming rate hike cycle into the Bund curve. So far, it is too early to tell and we would need to see follow-through action by the ECB. My guess is that an increase in the size of the EFSF and a broadening in its mandate could come together with a bail-out of Portugal. First, the actual size of the EFSF would not be enough to provide a bail-out for Spain - the domino behind Portugal - and therefore the urgency for change is intensifying even further at that stage. Second, I think that it would need a concrete event (the bail-out of Portugal) for such a decision to be taken to appease the public in the core countries. Economically it would make more sense to go down that route already now (i.e. somewhat preemptively) but politically it might be harder to do.
Overall, I remain of the opinion that Ireland, Portugal and Spain have the ability to solve their combined over-indebtedness and uncompetitiveness issues over a time horizon of 3-5 years (Greece will have more problems to do so). Establishing a positive feedback loop via a massive bond-buying programme would go a long way towards providing these countries with the necessary time. I have argued already in May last year (Wirtschaftswunder 2.0 - longer-lasting high growth period ahead for Germany) that re-establishing corporate competitiveness will occur not only via sustained lower growth & inflation in the periphery but also via higher growth & inflation in the core countries, especially Germany. Furthermore, as the Eurozone balances again internally, its external current account balance will move from being around zero to a significant surplus. I see no reason yet why I should deviate from this scenario which compared to most commentators constitutes a positive outlook.

Collapse in Private Pension Funds' Assets a key reason for a secular rise in the savings ratio?

The OECD has released its 'Pensions at a Glance 2009' report. The report itself costs money but some excerpts can be found here. Furthermore, today's FT contains a brief summary here. The report contains some very interesting findings. The chart below shows the pensions fundes' real investment returns for 2008. Across the OECD, on average pension funds lost 17.4% in real value (unweighted by size) and 23% if weighted by size. The losses have been worst in those countreis where the equity share has been highest (unsurprisingly). Irish pension funds held about two thirds of their assets in equities vs. an average of 36% in the 20 OECD countries where data is available. Such losses are enourmous and I think will have several consequences. For one, pension funds are likely to become more risk averse following such losses (unsurprisingly those pension fund systems with the lowest share in equities/highest in bonds performed the least bad: Germany, Czech Republic, Slovakia, Mexico). Furthermore, such huge losses will affect the behaviour of retirees and especially those near retirement in those countries where private funded pensions make up a significant contribution of retirees income. In 5 countries private financial sources make up more than 40% of retiree incomes: Australia, Canada, the Netherlands, the United Kingdom and the United States (closely followed by Denmark and Ireland).
In turn we should expect that especially people near retirement (and parts of the retirees) which have relied on private financial sources for their retirement are forced to save more. This can happen either via spending less or via working more (and retiring later). But clearly, this is an age group where we should expect savings ratio to rise significantly. It is therefore no surprise to see that savings ratios in the countries most affected by the loss in private pensions funds' wealth are increasing dramatically (from an albeit low level). The chart is from News N Economics, see here for post.
Finally, given such a reason for rising savings ratio, this rise in the savings ratio does not promise to be a short-term temporary affair but rather of a more longer term nature! Besides, limiting consumption growth, it also prevents parts of the people near retirement from dropping out of the workforce. Both, factors are rather disinflationary than inflationary.

Is inflation just around the corner? Part II

The second group of higher inflation advocates focuses on the increase in base money via the lengthening of central banks' balance sheets as well as the huge fiscal deficits. Given that M*V=Y*P always holds (The amount of money times the velocity of money is equal to the amount of output times the price level) and M has been increased by an almost unprecedented amount, P needs to increase drastically as well. Furthermore, as fiscal deficits are ballooning and government's indebtedness will reach levels which cannot be repaid, inflation is the only solution to reduce the debt-to-gdp ratio.
First, is the lengthening of the central banks' balance sheet really such a big problem? I doubt it. For one, I regard more the broad credit aggregates as being important for creating inflation than the narrow central bank money aggregate (that is to say I would not use M0 in the above formula but rather M3, M4 etc.). In fact, the US Fed has increased its balance sheet from around 850bn in mid-2007 to around USD900bn in early September and then in the wake of the Lehman bankruptcy to around USD2200bn by the end of 2008. Since then, the size has been fluctuating around USD2100bn. However, this size pales in comparison to the broad credit aggregates in the US economy which are estimated to be around USD50trn. The lengthening of the Federal Reserve's balance sheet came about by buying assets to stabilise credit markets (with the buying of US Treasuries being only a small part). However, this buying was not enough to a) help restore private credit markets to work properly again and b) lower yields on credit instruments (bar shorter-term securities) to levels below those prevailing at the onset of the financial crisis in 2007. In turn, for most economic agents (bare the government), monetary conditions remain tight (even though the credit crunch has eased over the past months) in terms of yield levels and availability of credit. The deleveraging by corporates and private households has only just started (see the higher households savings ratio) and the broad credit aggregates are unlikely to grow significantly over the next quarters. In turn, the velocity of money ("V" in the above equation) will remain depressed and the inflationary impulse provided by the lengthening in the Fed's balance sheet will not hit the real economy/will not be enough to offset the deflationary forces of the private sector deleveraging. Finally, I think that most of the enacted credit easing can be reversed relatively easily. A lot of the credit easing has been conducted via shorter-dated paper. In turn, even once the economy has moved back on a self-sustainable growth path, the Fed does not need to actively sell most of its holdings. Rather they can stop their buying programs and let existing paper mature.
I am more concerned with the size of the fiscal deficit and the ballooning debt-to-gdp ratios as history has shown that it is very difficult to reverse a structural budget deficit. However, I still fail to see how this can have significant inflationary consequences on its own as long as the state does not default/the currency does not depreciate sharply and/or as long as the central bank can conduct monetary policy independently (and I am convinced this is still the case in the Eurozone and the US).
Here, the USD's reserve currency status will prevent both: a funding crisis and a sharp devaluation. I think that the talk about a sharp USD devaluation is much overdone. For one, I do not see any alternative to the USD for the next years and additionally, the US remains the most important export market for most of the producing world. The situation in the UK remains very different though as no-one really needs to hold GBP.

So overall, I do not believe that inflation is just around the corner due to higher oil prices. Furthermore, I am not worried as well that inflation will skyrocket once the economy recovers given the huge level of excess capacity, the ongoing debt-deflationary process and the ability of central banks to reduce the balance sheet again if need be.

Is inflation just around the corner? Part I

There are several groups of inflation advocates. One group - similar to last year - focuses on rising commodity prices (especially oil), while another is concerned about the lengthening of central banks balance sheets and the huge fiscal deficits. In the first case, inflation is just around the corner while in the latter, inflation will be ballooning (with several proponents calling for double-digit inflation rates) once growth recovers. I still fail to see noticeable inflation pressures unless we see a currency crisis/sovereign default a la Iceland.
The rising oil prices will have some impact on headline inflation rates. However, even more so than was the case one year ago, this constitutes much more so a change in relative prices and a negative terms of trade shock for an oil-importing country. Higher oil prices mean that corporates and households need to pay more for their energy consumption. It does nothing to help increase nominal wages (with the exception of some countries where there is still wage indexation) or employment (rather to the contrary). Excess capacity in the form of unused production capacity and unemployment is much more prevalent than 12 months ago which will render it very difficult to pass on energy price rises. It therefore should reduce profit margins even more than last year. Additionally, higher headline inflation due to rising energy prices will not render houses any cheaper or lead to a real reduction in indebtedness. Inflation only helps to prop up house prices/reduce household indebtedness if it is mirrored by rising rents (which reduces the house-price-to-rent ratio and unless house prices rise, increases the expected return on purchasing a house as an investment) or rising wages (which helps to pay back debt).
In turn, I do not expect that higher commodity prices (in commodity-importing countries) will lead to higher inflation rates bar a temporary blip. Rather to the contrary, they dampen any economic recovery and put more downward pressure on core inflation rates. Furthermore, I expect the run-up in oil prices to be partially reversed again during the next weeks and months (more on that in another post).

Recovery or just getting less bad?

The 'Green Shoots' are becoming more widespread in terms of data releases within the US but also geographically as reports about Green Shoots are spreading across the globe. Still whether this will be a real, longer-lasting recovery, a shorter blib in growth followed by a double-dib or whether this will turn out to be just mirrored with GDP shrinking less fast (i.e. growth being less negative). While I personally believe in the second scenario (with an overall multi-year adjustment period to the previous excesses where we should expect qoq growth rates to oscillate around 0% for a prolonged period of time), the truth is that we just do not know yet. But what we know by now is that compared to the consensus scenario earlier this year, things are starting to look less dire indeed. And for the markets, less dire means brighter. We are still in the process where the outlook is becoming less dire (consumer and business sentiment is improving, growth expectations are raised again etc.). In turn, the recovery in risky assets - albeit starting to look extended - does not seem over yet. I believe that only once the upward correction in sentiment and growth expectations is over (which will probably take another few weeks) could we see more than just correctionary bear moves. While government bonds should face more headwinds in the short term, I expect that over the next 1-2 weeks government bond yields should stop rising, slowly followed by yields trending towards the 3% again for 10y Bunds and UST during summer.