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Monday June 18, 2007 - 11:44:12 GMT
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Forex Market News - Economics Weekly: Bond yields rise as ‘risk’ premium increases; Weekly economic data preview: BoE minutes in focus: did any MPC member vote for higher rates?

Economics Weekly:

Bond yields rise as ‘risk’ premium increases

Bond yields are rising...
In an article a few weeks ago, we argued that it was not inflation expectations that were keeping nominal bond yields down but the ‘real’ rate. This was based on evidence that inflation expectations had risen yet bond yields were still well below fair value, in other words, they were low only because the real return being demanded by investors to compensate them for the risk of holding bonds was at an historical low level. But now this has changed and investors’ risk premiums have risen sharply. How do we know this?

The answer is shown in chart a. Here, we draw US inflation protected bonds yields (TIPS) – taken as the
real rate - versus nominal bond yields minus the TIP rate (the implied inflation rate). This shows that the reason for the rise in nominal bond yields in the last few weeks is mainly due to a higher real rate and not inflation expectations. But the chart does show that since the start of 2007 there has been some rise in inflation expectations. What this means overall though is that the financial markets are fairly confident that the rise in official short term interest rates around the world will keep inflation under control.

...but the reason is down to greater risk pricing rather than inflation...
But this then begs the question of why bond markets are now pricing for greater risk rather than some months ago? The answer seems to be partly that central banks are now raising short term interest rates more aggressively around the world in a decisive move to get rates back to ‘neutral’ or tight levels. This has caught out fixed income investors who had been expecting weaker US growth to lead to a cut in short term interest rates and perhaps for weaker global growth as the US slowdown hit other economies. It has not happened that way.

Instead of the global economy weakening as a result of slower growth in the US, it has accelerated. Growth in the emerging markets (chart c), especially the giant economies of China and India are rising at the fastest pace seen for well over a decade (in the case of India a 19 year high in Q1) and they too are increasing interest rates. Growth has been fast even in the developed economies, see chart b. Indeed, economic expansions in the EU, UK and Japan are at a faster pace than that of the US. One may ask why this is and clearly the reasons lie in the emergence of alternative growth engines in the rest of the world to that of the US and to the self sustaining basis of that growth. (China, India and Russia again spring to mind). However, growth in the US too has been very resilient. The Fed has been reluctant to cut rates because inflation remains near the top of its 1-2% comfort zone, but more than that, it looks as if US growth is likely to be recovering in the next three quarters of 2007 and into 2008. This means that rate cuts are out of the question in our view next year as well as this, especially if, as seems likely, it will coincide with continued fast global growth and with the US labour market showing an unemployment rate of just 4.5%. Further, there are some signs that manufacturing growth is also accelerating, helped by a cheaper dollar and the global backdrop, which will put pressure on capacity utilisation. So bond markets have finally realised that short term interest rates are not going to fall and growth is stronger, and it is this rather than a rise in inflation expectations that has driven up nominal bond yields.

But why would growth cause real yields to rise if the reason is not linked to the inflation that this faster growth will cause? The reason is that growth is almost everywhere being led by investment – in the US, in the eurozone, in the UK, in China, in India, all of which implies rise in the demand for capital. In turn this implies that the global mix between saving and investment is shifting so that one should expect to see a rise in real interest rates given the integration of world capital markets. This effectively means that since global savings are being used for investment, there is less for other purposes and a rise in the cost of capital is inevitable.

...this has some key implications for financial markets.
But does this mean that the high liquidity, low real interest rate and so benign credit conditions of the last 5 years or so are about to end? We think not, partly because this will be a slow process but mainly because the other reason for low interest rates is low global inflation stemming from open markets and tough anti-inflation policies by central banks. We do not expect that to end. But we do believe that the era of very easy money is over or nearly so and this implies that credit conditions will tighten, as suggested by the wider spreads in the vix and itraxx although still perhaps too modest, see chart d. The latter will likely see more
adjustment as a rise in real rates implies that there may be more defaults and a higher cost attached to
them. For equities (see chart e), the view expressed in the fast rise of the last few years - faster economic growth and so strong company earnings - has been vindicated and since faster economic growth led by investment is good for equities, there should be no sharp fall due to the rise in real bond yields.

The implication of a consistent higher real bond yield is that economic growth may be slower than otherwise,
but that will keep down inflation and so perhaps the inflation part of the nominal bond yield may moderate any rise in overall yields. In any event, a rise in real bond yields implies that the rise in short term interest rates may also be less than otherwise. For some, this raises a risk for the US given housing market weakness, but it may mean instead that the Fed keeps short term rates on hold all of next year rather than raising them. For the UK, the implication is the same; the MPC may not need to raise short term rates much above current levels, if at all. For the eurozone, it fits in with our view that rates may peak at 4.5% early in 2008. But the bigger story is that a global adjustment from easy money is underway and the pool of global savings in Asia and the oil exporting countries is being used more for investment than for consumption in the US. This has many implications for financial markets and the global economy. But so long as economies remain open the adjustment process will be gradual and lead to a fall in the US current account deficit and a more stable dollar.

Trevor Williams, Chief Economist

Weekly economic data preview

BoE minutes in focus: did any MPC member vote for higher rates?

• The minutes of the June BoE interest rate meeting are due on Wednesday and will be the focus this week in the UK as financial markets continue to debate the likelihood of another rise in base rates this summer. M4 money supply, mortgage lending data and an update on public finances are due on Wednesday. The latest CBI industrial trends survey will be published on Thursday.

• A quiet week lies ahead in the US. One week before the next Fed decision on interest rates, markets will concentrate on housing starts and building permits on Tuesday to assess levels of residential construction halfway through the second quarter. Signs of a pick-up in economic activity in the current quarter could lead the Fed to make a more positive statement on prospects for economic growth in the FOMC statement next week.

• In the euro zone, we wonder whether the rise in bond yields and the outlook for higher euro zone interest rates may have adversely impacted the German ZEW survey of economic sentiment. The ZEW survey will be released on Tuesday. Flash estimates for EU-13 manufacturing and services PMI's will be published simultaneously and for the first time on Thursday. The German IFO survey of business sentiment is due on Friday and may show that growth prospects for manufacturing are consolidating at a high level at the end of the second quarter.

Reports last week of a decline in UK CPI inflation to 2.5% in May and a slowdown in average wage growth to 3.6% in April should have helped to defuse some market speculation that the Bank of England (BoE) is on standby to raise interest rates again this summer. However, a slightly stronger than forecast 0.4% rise in retail sales in May, despite bad weather, is a testimony to strong consumer demand which could keep inflation pressures in the economy bubbling. Separately, the BoE inflation survey showed that inflation expectations remained steady at 2.7% for a 3rd successive quarter in May. This leaves higher interest rates in the balance if price pressures do not subside any further in the months ahead. This brings us to the release of the minutes of the June MPC meeting on Wednesday which top the UK agenda this week. The MPC may have voted unanimously to keep rates at 5.50% earlier this month, but we feel there is a risk that at least one member may have voted for higher rates. It is worth remembering that some policy members were of the opinion at the previous meeting in May that a half point rate increase could have been justified rather than a quarter point move. M4 money supply data has been a source of concern for inflation for a while and we do not expect any moderation in money supply growth in May. Mortgage lending has shown sign of slowing housing market activity this spring and figures on Wednesday will be watched to check whether higher mortgage rates weighed on demand for new lending in May. The CBI industrial trends survey for June is out on Thursday. The survey last month showed that manufacturers are growing more confident about their ability to increase prices, and evidence that this was the case again in June could strengthen market confidence that rates may rise to 5.75% (this is not our forecast).

Financial markets in the US last week moved another step towards pricing in a different outlook for US interest rates. Strong economic data for retail sales and mortgage applications led futures markets to price in 13% odds that the Fed will raise interest rates by the end of the year. Despite high petrol prices and the increase in mortgage rates to a near one-year high, household optimism has not wavered. However, whilst the US economy appears to be in the middle of a rebound from Q1, there are still some pockets of uncertainty and weakness. These mainly relate to residential construction which, due to the excess level of housing stock, is likely to remain a drag on overall US economic activity in the coming quarters. Housing starts and building permits data for May will be released on Tuesday and will give an update on levels of construction. Weekly initial claims data on Thursday coincide with the cut-off date for the June employment report and should therefore attract some additional interest as markets start the countdown towards the two-day Fed FOMC meeting on June 27/28.

In the euro zone, we forecast a small decline in the German ZEW survey of economic sentiment on Tuesday following the turbulence in bond and equity markets and the unexpected 2.3% drop in German industrial output in May. We also forecast a drop in the IFO business survey to 108.3 in June from 108.6 in May as demand stabilises. The new flash manufacturing and services PMI's for the euro zone will be published for the first time on Thursday and will give some indication about levels of price pressures and employment trends.

]Kenneth Broux, Economist

Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE,
0207 626 - 1500

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