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June 2017 | Macro Insights

Roundtable: Strategy in the Not-so-Great Reflate

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The weak transmission of growth to inflation in the developed world creates challenges for policymakers, raising the risks of a policy misstep. We talked to our specialists in the markets most exposed to inflation developments about what investors should be watching.

 

In your quarterly meetings you highlighted a contrast between synchronized global growth and dispersed inflation. How did this disconnect arise and why do we care?

Bayliss: Despite the momentum in this coordinated global growth upswing, its transmission to inflation has been weak. Output gaps vary across the developed world, and even where labor markets are tightest in the US, Japan and Germany, wages have been slow to respond.

Van Wyk: This disconnect is important because the lack of momentum in inflation could lead markets to underestimate the strength in the global economy. For the first time in a while, global growth is benefitting from a coordinated positive impulse in the major economies. This synchronized expansion could lead to more convergence of monetary policy and materially higher rates.

Moreover, if global inflation is more synchronized than it currently appears—if excess capacity is coming down and price pressures are trending higher globally—yields have a lot of room to rise. We think the most likely scenario is a gradual increase in risk premia in government bond markets, starting with the US, but we see a tail risk of volatility in rates that could spill over to broader markets. 

What is your outlook for inflation across core developed markets?

Van Wyk: In short, we believe inflation is a long way from normalizing in Europe and Japan, but will reach its target in the US next year. The outlier is the UK, where the Bank of England has resolved to look through a significant inflation overshoot in the near term, given that currency effects have been the main driver of inflation and the economic impact of Brexit remains highly uncertain.

Does this dispersion in inflation mean we are likely to see further divergence between monetary policy in the US and in other major developed economies?

Dangoor: Policy divergence has peaked, in our view. The US is the only major central bank tightening but Japan and Europe are getting closer to tapering QE (see “The Quiet Exit,” in our quarterly Fixed Income Outlook), and the UK’s next step is probably more likely to be a hike than a cut. That said, we don’t see the ECB and Bank of Japan removing monetary accommodation any time soon—we don’t expect a rate hike in Europe before 2019.

How does your inflation and policy outlook inform your strategy?

Bayliss: Inflation is a critical development for the rates markets, and our expectation for continued dispersion drives our global relative value strategies. Our below-consensus forecast for European inflation is our highest conviction view, and one of the main reasons we are positioned for core European rates to outperform both the US and UK markets.

We see little value in directional trades in markets where inflation is weakest. Rates are already so low in Europe, and in Japan the BoJ’s yield curve control policy has removed volatility from the government bond market. In the US we are positioned for yields to rise, based on the view that markets are underpricing the likely trajectory of Fed hikes. We believe inflation is currently the most important input to Fed policy as the dual mandate of maximum employment and inflation is only half-fulfilled.

Dangoor: In inflation markets, we look for opportunity in discrepancies between the inflation expectations and policy response implied in real and nominal markets, respectively. For instance, euro real yields suggest inflation won’t come close to target in the next couple of years but nominal rates suggest the ECB will tighten next year. We think this creates relative value opportunity. We see similar, but opposite, discrepancies in the UK markets, which suggest inflation will remain high far into the future, well past any inflation related to last year’s currency depreciation and yet monetary policy is also priced to stay very easy for many years.

In the US our current positioning in Treasury Inflation Protected Securities (TIPS) is smaller than it has been, given better valuations. However, these securities do still offer reasonable long term value with much of the breakeven curve priced below the prevailing trend in core CPI and significantly below the Fed’s implied inflation target. 

US inflation has showed signs of slowing recently. What would change your view that the market is underpricing the Fed rather than the Fed overestimating its trajectory?

Bayliss: As long as growth remains strong we believe inflation will come. We are focusing on the transmission of labor market tightness to wages, and from wages to core inflation. If we believe that any part of that process from tight labor to higher inflation is not working, then we’ll revisit our view. With two downside surprises on the consumer price index we’re thinking particularly about the relationship of wages to core inflation. We aren’t setting specific levels to signal dysfunction in that relationship, but we’re scrutinizing the drivers item by item and we still feel the weakness is transitory and the transmission is intact over the medium term. 

Has this long period of below-target inflation made it more difficult to predict central banks’ reactions in an environment of rising pressures?

Dangoor: Broadly speaking we would expect major central banks not to be anchored to specific interpretations of inflation index readings. To the extent that inflation is driven higher or lower by non-domestic factors, we think policymakers are willing to look through fluctuations. But central banks now have limited tools to react to negative economic shocks, so the process to resolve low inflation may be slower than the process to correct an overshoot. If the tools are better to tackle an upside surprise, then central banks may be more inclined to look through above-target readings. Moreover, there may be a rationale for compensating periods of low inflation with periods of high inflation to help boost expectations. 

What underpins your conviction that European rates will continue to outperform?

Bayliss: Europe’s economy is clearly improving. The ECB’s summary of growth as broad-based and resilient is probably fair, but the translation to higher inflation could be protracted for several reasons. First, the output gap is still wide. Unemployment in the periphery is still in double-digits, and we think labor market slack may be greater than the headline rate suggests. Second, we expect structural reform in France under President Emmanuel Macron, and possibly also in the periphery over the next few years. Such reforms are likely to be deflationary. And third, inflation expectations are depressed after a long period of weak price pressures.

Why is wage growth still so slow in Germany?

Bayliss: German wage growth remains sluggish despite unemployment having fallen to a post-reunification low of 3.9%. This weakness is a function of both demographics and geography. First, companies in more-affluent parts of northern Europe can still find cost advantages in relocating to the peripheries, and this proximity of cheaper labor weighs on organized wage negotiations. But more importantly, cheaper labor is coming to Germany, which has embraced immigration as a solution to its aging demographics.

Germany is an attractive destination as the strongest economy in Europe, and workers in neighboring low-wage countries—where unemployment rates may be up to three times higher—have easy access to Germany’s job market. As a result, 57% of new jobs added in Germany over the past five years have gone to foreigners, who tend to have very little bargaining power on wages.

The flow of refugees into Europe from the Middle East is also adding to the prospective pool of labor in Germany and other countries where unemployment is lowest, such as Sweden. However, we believe this migration probably peaked 18 months ago, and labor capacity will be absorbed into the workforce over the next few years.

What are the risks to this view?

Van Wyk: We could see a faster pickup of inflation in Europe now that the rest of the world is comparatively healthy. Europe’s path from a tight labor market to wage growth to inflation may not be as prolonged as it was for the US, which has made this transition during a period when global growth was weak. It’s hard to steal growth from countries that have no growth to give, and there’s no magic that brings inflation about even as unemployment reaches the threshold.

Germany is surrounded by disinflationary wage pressures

Germany-is-surrounded-by-disinflationary-wage-pressures

Source: OECD. Average annual wage in 2015 constant prices at 2015 EUR PPPs, estimated using 2015 USD PPPs and average 2015 EURUSD spot rate.


About the Authors

Jonathan Bayliss

Jonathan Bayliss

Head of Macro Rates Investing
Simon Dangoor

Simon Dangoor

Head of Country and Co-head of Government Swaps Strategy
Mark   Van Wyk

Mark Van Wyk

Global Head of Government Swaps Investment Strategy

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