LONDON, 8 March 2004 — Data for the US consumer price index sent a chill wind through the markets. Although the “core” rate only rose 0.2 percent, the headline number increased 0.5 percent, reflecting chiefly the impact of much higher energy pries. Admittedly, the year on year increase in the core inflation rate is only 1.1 percent. However, this figure does not provide much reassurance as inflation reacts very slowly to changes in economic conditions and monetary policy.
As the influential columnist of the Times — Anotole Kaletsky — points out, there are at least seven separate trends, which point to higher us prices in future. “First and foremost, an extremely lax monetary policy, with interest rates some five percentage points below the growth of nominal GDP; second, ballooning budget deficits; third, a depreciating currency; fourth, a hugely expensive war financed by printing money; fifth, protectionism; sixth, a soaring oil price; and seventh, a profligately extravagant government, now promising to send a man to Mars.”
And yet, the market which has most to fear from US inflation — the US Treasury market — has continued to go up this year. The yield on the 10-year bond was over 4.2 percent at the end of December 2003 but is now around 4 percent. Why is this? Part of the answer is that many investors are wrong-footed. So convinced were they that bond yields would rise, they are now underweight in long-dated governments, thus confirming the old saying that markets move in the direction which causes most pain. Another part of the explanation has to do with Asian government buying. Some see this as a way of mitigating US pressure for currency revaluation.
Another important support for US Treasuries is the market’s willingness to believe Greenspan and the other Fed officials when they indicate that they won’t raise interest rates anytime soon. As Kaletsky points out, Greenspan has come up with a new argument as to why “this time it is different” and why deflation is more of a threat than inflation. This is that central banks have already proved they can deal with inflation, and presumably could do so again if necessary, but their ability to resist falling prices is as yet untested.
Quite apart from such sophistry, many doubt that the Fed would resist White House pressures to keep rates where they are in an election year. Money rates at 1 percent exert a gravitational pull on long bond yields, even if investors fear that the Fed is conniving at a build up of inflationary pressure over the longer-term.
All major markets — commodities, government bonds, corporate bonds, equities — have risen over the last year, given the easy liquidity environment which has prevailed. The signs are that liquidity is se tot remain easy and, therefore, markets can probably move higher over coming months even though they may not offer much “value”. We are focusing on the US Treasury market to give warning signs that the investment environment is turning less favorable.
(Habib F. Faris is vice president at Clariden Bank, London.)
(The information contained here in is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information)