"What should I be for Halloween?" The text message question flashed on my smart phone while I sat in a meeting earlier this week.
"Go as inflation expectations."
My brother, a high school teacher with little to no interest in financial markets, shot back: "Huh?"
So I explained: "Falling inflation expectations always seem to be enough to frighten the world's most powerful central bankers into action. Try it out on your students and colleagues."
Needless to say, he ignored my advice and chose another costume.
But the point stands: as what we at Payden like to call "the Halloween FOMC meeting" approaches next week, disinflation haunts central bankers.
In the US this week we learned that core inflation dipped to 1.7% on a year-over-year basis in September. Since this measure produced by the Bureau of Labor Statistics tends to overstate inflation in the Fed's preferred gauge by 50 basis points, we expect central bankers to raise a few eye brows. Add to that the fact that the only major component of the index that is really "inflating" is the housing component. CPI ex food, ex energy and ex housing is up just 0.9% over the last year. Further, we don't think rising monthly rents and disinflating everything else will be the inflation mix the Fed was hoping for.
Importantly, this is not a US story. Of the 46 countries with "inflation targets" 30 are experiencing below target inflation. The vast majority of countries on Earth have inflation below 3%. But it isn't just inflation today that is low. Expectations of future inflation--a key determinant of future inflation in macro models employed by the world's macro technocrats--have also declined significantly since the summer. A quick look at inflation expectations out of the US and euro area provide plenty of "boo" for policymakers. US CPI swaps fell from 2.9% at the beginning of August to 2.6% today. Euro area CPI swaps fell from 2.1% to 1.8% over the same time period.
Cautiously, some of our traders tell us, "Well it's just oil pushing inflation expectations lower," or "the stronger dollar only pushes inflation lower today, not in the future." To which we hastily reply: "It matters less what's behind the move than the move itself." Once ingrained, lower inflation expectations prove mighty difficult to dislodge. Japanese policymakers have wrestled with this fact for nearly two decades. But, now, it's no longer isolated to an island nation in the Pacific.
More important for investors, though, falling inflation expectations often precede monetary policy shifts by spooked central bankers. In the summer of 2010, falling inflation expectations prompted talk of QE2, which eventually arrived at the Halloween FOMC meeting. In the summer of 2011, right after QE2 ended, the Fed unveiled Operation Twist as the economy stalled, jobs disappointed and, yes, inflation expectations tumbled. In 2012, a fall in inflation expectations presaged QE3's launch and the adoption of the famous Evan's Rule (interest rates stay at zero at least until we see 6.5% unemployment, and so long as inflation stays below 2.5%).
So what's different in 2014? In our view the US economy in particular is in much better shape. We've experienced nearly four years of steady job growth. That said, global growth, trade, and inflation look worse. Perhaps the data are not enough to drag down the US economy but the impact on US inflation is worth noting. As the world's foremost inflation-targeting central bank, global disinflation and falling inflation expectations will not go unnoticed by the Fed: whether they choose to acknowledge the backdrop at the meeting next week or prefer to skip by and hope for a revival (inflation expectations have actually bounced up a bit this week, for example) by the December meeting is another question.
Long telegraphed to end at the October meeting, prolonging QE3 is perhaps a low risk, easy commitment that would prove the central bank really is data dependent and worried about both sides of the dual mandate. At the very least, acknowledgement of persistently low US and global inflation could jump off the page in the 900+ word post-meeting policy statement. Any hints of an imminent move toward tighter policy should be absent--an important departure from market expectations/worries of just a few weeks ago.
As we approach the "Halloween FOMC meeting," watch out for central bankers frightened by inflation expectations.
Investment grade primary issuance met expectations of $20-25 billion for the week, with roughly $25 billion tapping the market. Volatility in the market is still very high, with more days than not this week experiencing an equity swing of greater than 1%. Equities are finally seeing gains after large losses in the first half of October, supported by recent favorable international data and generally positive earnings reports. One notable deal this week came from Verizon, which issued a total of $6.5 billion across seven, ten and twenty year tranches. Although the deal initially planned to include a five year tranche as well, the issuer decided to pull it, despite heavy demand for it. In total, the deal was three times oversubscribed and each tranche tightened by 15 basis points from initial price talk, only to widen five basis points on the break, now trading flat on average to where they priced.
Investment grade corporate spreads saw some movement this week when the ECB suggested purchasing corporate bonds to add to their balance sheet, resulting in several basis points of spread tightening. This reversed when the market realized that there was no actual plan behind these words, losing some (but not all) of the gains taken on the news. The Corporate Index Option-Adjusted Spread (OAS) finished the week at +117, three tighter on the week. Overall, Senior financials were four tighter, Sub financials six tighter, Metals/Mining tighter by five, Media names are four wider on the back of the Verzion deal which caused clients to sell names that have outperformed lately possibly making room for potential issuance. Industrials tightened by two, Tech and Healthcare were both three tighter.
Emerging market dollar-pay spreads tightened to 308 basis points over US Treasuries, as markets recovered following the US equity sell-off, while local yields tightened to 6.48%. Emerging market currency performance was mixed against the US dollar; depreciation was led by the Russian ruble (-2.0%) and the Czech koruna (-2.0%), while the Indonesian rupiah gained by (+1.6%) and South African rand by (+1.3%).
Moody's lowered Russia's sovereign debt rating by one notch to Baa2 citing weakened medium term growth prospects. The ongoing crisis in Ukraine has weighed on Russian growth, creating a negative macroeconomic environment. Meanwhile the decline in oil prices has eroded Russia's FX position, another trigger for downgrade, according to the rating agency. Subsequently Moody's downgraded government related issuer Russian Railways to Baa2, reflecting the weakening credit profile of the sovereign.
China reported Q3 GDP at 7.3% y/y, the slowest pace since Q1 2009, largely due to the slowing property market and tighter monetary conditions. Going forward, Q4 growth is expected to pick up marginally on the back of stimulus measures introduced by Chinese policymakers. Elsewhere in Asia, India announced fuel price deregulation, taking advantage of lower global oil prices. The fuel reforms are expected to remove the bulk of the energy subsidies, which will enhance fiscal management and boost sovereign ratings over the long term. The Central Bank of the Philippines held rates steady at 4% in line with expectations. Lower oil prices have given the central bank some breathing room as inflationary pressures cool.
The Central Bank of Turkey kept rates steady at 8.25%. The central bank noted that the 25% reduction in Brent oil prices have significantly improved the inflation outlook. Meanwhile favorable base effects will support headline inflation in the coming months, while the external backdrop remains challenging.
Emerging market debt funds saw outflows of $0.2 billion, led by local currency and blended funds.