Thinking about Prices

Investors have a robust appetite for risk as financial assets remain strong, but there is a nervousness below the surface. The current trajectory cannot be sustained. The US equity market, for example, has gone nearly 180 days without a 5% correction.

With the central banks of the US and Japan buying a combined $160 bln a month in assets, the ECB providing as much liquidity as the banks want and have collateral for, and renewed reserve growth among the emerging markets, orthodoxy warns of the risk of inflation and higher commodity, especially gold prices. 

This is not the case. The CRB Index is 6.5% off the January high and is 40% lower than the 2008 peak.  Gold is trading more than 20% below its Q4 12 peak.   The bounce after the dramatic sell-off in mid-April fizzled at Fibonacci retracement objective (~$1488).  The break now of $1400 warns of a return to the panic low set near $1322. So much for buying claims on real "stuff" to protect one from the so-called financial repression of negative real interest rates. 

The Fed and the ECB have recently noted the weakening of price pressures. If one excludes food prices, China's CPI is near euro area and US core levels, well below 2%.  Japan, Switzerland and Sweden are experiencing outright deflation. On the European periphery, deflation is beginning to become evident in Greece and while disinflation is evident in Germany, France, Italy, Spain and that Netherlands.    

The disinflationary environment is particularly hard on the periphery of Europe.  In order for them to boost competitiveness, their prices have to rise slower than Germany's for an extended period.  However, Germany CPI was up 1.1% from a year ago on an EU harmonized basis.   Some observers have talked about the Fed's QE exporting inflation, though it is difficult to see where, surely not its biggest trading partners.  More recently others have argued that Japan's QE will exporting deflation.  Yet, Germany's low inflation forces deflation on the periphery, regardless of what the ECB does with the interest rates.  

Japan's Prime Minister Abe has advocated higher wages as an essential part of efforts to restructure  and revive the world's third largest economy.  While corporate earnings and their outlook have been boosted by the weakness of the yen, businesses are still reluctant to share the spoils, though some bonus payments were raised.  

It is a different story in Germany.  IG Metall, the workers' union, and Gesamtmetall, the employers' union struck a wage deal earlier today.  Some 770k workers covered by the agreement will get a 5.6% wage increase over the next 20-months.   The union had sought a 1 year contract for a 5.5% pay increase.  

IG Metall represents 3.7 mln workers and this deal will influence other wage negotiations, but there is greater regional and industry variation than before.  Note that Bavarian IG Metall workers had previously won a 3.4% wage increase starting July 1 and another 2.2% increase next May 1.   Bavarian labor market is tighter and unemployment lower than the national average.  

Europe is only now appreciating the banker patriarch Mayer Rothschild, late 18th century insight,  "allow me to issue and control a nation's currency and I care not who makes its laws".   While this assessment appears right as rain, perhaps if Rothschild were alive today, he might amend this to say, "but let me divide the social product between labor and capital and I can protect myself from the vagaries of exchange rates".  

Some US officials recognized that boosting Chinese wages, broadly understood, was the real key adjusting the competitive imbalance not the exchange rate.  Higher German wages (unit labor costs) would do more good for France, Italy, Spain and for the cohesion of Europe than a 25 bp refi rate cut by the ECB.     

The significance of the dramatic sell-off in Japanese government bond despite the fact that the BOJ is buying 70% of the new issuance is not fully appreciated.  Media reports largely emphasize domestic funds reallocating away from the JGB market and into equities and foreign bonds.   Some accounts suggest the backing up of US rates has helped drag Japanese yields higher.  

There are two components to yield.  There is the real rate and the risk premium.  This risk premium in the high income economies is understood to be largely inflation risk.    These are more difficult to measure, especially given the large bid by the central bank for JGBs, but it appears that the rise in the 10-year yield is largely a function of higher inflation expectations. 

The 10-year JGB was yielding 75 bp before the election was announced last Nov.  It had been trending lower and discounting the spikes in early April around the BOJ's announcement, it seemed to consolidate around 50 bp.  Today it tested 90 bp a new 12-month high.  

One way to try to get our hands around inflation expectations is to compare the yields of conventional bonds with the real yield of the bonds tied to inflation.  The 5-year  "break-even"  was just above 70 bp last November and rose to 160 bp in early March.  The uncertainty over the new BOJ governor nomination saw a period of consolidation, but today it made new multi-year highs of near 190 bp. 

Ironically, Japan may have lower real interest rates despite the higher nominal yields and this will confuse many.