Recap 2015-01-07

Commentary:

Note that this entire move in US yields over the past 1.5 years has been driven by the inflation component. (thanks Steve) Take a look at this chart of the 10yr US treasury yield in white on top, the 10yr TIPS yield in orange on top, and the 10yr inflation breakeven (i.e. inflation breakeven) on the bottom. Basically, the 10yr real yield has been really stable for about a year and a half now. Basically the entirety of the move since mid 2013 was due to the break even component.

A 60-70bps drop in 10yr inflation expectation off the move in oil makes very little sense. Energy is only 10% of the CPI basket, and only affects realized inflation for one year. In addition, at ~150bps, 10yr breakevens are now at the lows last seen when people thought the US was going to enter a double dip recession.

The FOMC seems slightly concerned about this based on the minutes, but Yellen’s reference to break-evens as ‘inflation compensation’ probably means that the effect on policy may be limited. IMO, short US bonds is still the right call longer term on a fundamental basis. Obviously over the short term, anything can happen.

Separately, an interesting bit from GS on a potential €500bn ECB QE program: if purchases are determined according to the ECB’s capital key contributions (which is our baseline assumption), the ECB would buy about EUR130bn of German securities, EUR100bn of French, EUR90bn of Italian and EUR60bn of Spanish securities, equal to about 90%, 60%, 43% and 45% of the respective 2015 gross issuance. These numbers are closer to the amount of “supply removal” of the BoJ under the current asset purchase programme. The latter is buying approximately 50% of gross issuance of JGBs and about 90% of gross issuance of 10-year JGBs.

Notable:

  • FOMC Minutes:
  1. The risks to the outlook for economic activity and the labor market were seen as nearly balanced.
  2. Participants generally regarded the net effect of the recent decline in energy prices as likely to be positive for economic activity and employment.
  3. Although a few participants suggested that the recent uptick in the employment cost index or average hourly earnings could be a tentative sign of an upturn in wage growth, most participants saw no clear evidence of a broad-based acceleration in wages.
  4. Participants generally anticipated that inflation was likely to decline further in the near term, reflecting the reduction in oil prices and the effects of the rise in the foreign exchange value of the dollar on import prices. Most participants saw these influences as temporary
  5. Participants discussed various explanations for the decline in market-based measures, including a fall in expected future inflation, reductions in inflation risk premiums, and higher liquidity and other premiums that might be influencing the prices of Treasury Inflation-Protected Securities and inflation derivatives. Model-based decompositions of inflation compensation seemed to support the message from surveys that longer-term inflation expectations had remained stable, although it was observed that these results were sensitive to the assumptions underlying the particular models used. It was noted that even if the declines in inflation compensation reflected lower inflation risk premiums rather than a reduction in expected inflation, policymakers might still want to take them into account because such changes could reflect increased concerns on the part of investors about adverse outcomes in which low inflation was accompanied by weak economic activity. In the end, participants generally agreed that it would take more time and analysis to draw definitive conclusions regarding the recent behavior of inflation compensation.
  6. With regard to inflation, a number of participants saw a risk that it could run persistently below their 2 percent objective, with some expressing concern that such an outcome could undermine the credibility of the Committee’s commitment to that objective. Some participants were worried that the recent substantial fall in energy prices could lead to a reduction in longer-term inflation expectations, while others were concerned that the decline in market-based measures of inflation compensation might reflect, in part, that such a decline had already begun.
  7. Most participants thought the reference to patience indicated that the Committee was unlikely to begin the normalization process for at least the next couple of meetings.

US ADP Employment improved to 241k vs 225k exp, with another +19k revision to the prior print

EU Unemployment was stable at 11.5% in Nov as exp

EU CPI declined -0.2% YoY vs -0.1% exp and +0.3% prev. Core CPI ticked up to 0.8% vs 0.7% exp and prev

at least two gunmen have attacked the Paris office of French satirical magazine Charlie Hebdo, killing a number of people – BBC

Upcoming:

  • Wed: AU Building Approvals
  • Thu: BoE, Jobless Claims, China CPI
  • Fri: US Employment, Canada Employment
  • Mon: Japan Eco Watchers Survey, China Trade Bal
  • Tue: UKCPI, US NFIB Survey
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7 thoughts on “Recap 2015-01-07

  1. Nice note; I feel like I’m taking crazy pills when I look at some of these forward inflation moves….

    On the subject of ECB QE, with all due respect to the supply story, I suspect the ‘there aren’t enough bonds to go round’ argument is the exact mirror image of the ‘who’s going to buy all the bonds when QE ends’ argument.

  2. Please excuse my ignorance, but if Energy is 10% of the CPI basket and that 10% has a delta of minus 50%, then, all other components being flat, CPI YoY should go to minus 5%. In that case US Govies, particularly 10 Yrs Treasuries (given the shape of the yield curve), look cheap to me. Where am I wrong?

    1. Sure, in that case, cpi would be -5 for one year, not 10. In addition, if oil is unchanged from here, its weight in the cpi basket would also be smaller going forward, which reduces its future delta on cpi

      1. Nobody buys a 10 yrs Treasury to hold it until maturity. So if CPI prints lower and lower in the next few months, don’t you think going long 8-10 yrs Treasuries makes sense ?

        1. I am of course assuming that the FED doesn’t raise rates in 2015 because it misses its inflation target (contrary to the consensus).

        2. Actually, plenty of bond market participants hold bonds to maturity. The holding period vs maturity comparison is not applicable. i.e. Equities are infinite maturity instruments. Real money investors do not invest in equities based only on earnings 1 quarter forward.

          Furthermore, lower CPI prints are already expected by the market. Consensus forecasts for CPI has fallen sharply already. I saw one bank forecast a zero headline CPI in the coming quarter.

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