The credit crisis has dominated global market financial trends for almost three years. As we begin 2010, the specter of systemic risk has almost completely disappeared, and we find ourselves reverting to idiosyncratic risk and economic divergences that more typically define market opportunities. In many regards, 2010 will be an underwhelming year for those expecting paradigm shifts. Crises bring opportunity. Recoveries bring banality.
Economic growth will divide along a line separating the 2.7% or so likely in the G3 area, and the almost 6.0% expected in emerging Asia. Economic relegation and promotion dynamics are already defining subtle shifts to policy tack across and between countries in the months ahead.
Monetary policy will not be tightened in a meaningful way globally until 2011, but central banks will continue to tailor interest rates to domestic conditions leading to small but cumulatively important policy differences over the year ahead. The need to hedge against global collapse has gone. Fiscal policy will not be tightened dramatically anywhere until 2011, but rating agencies will have their say this year on where the dynamics looks untenable. The data flow so far this year is about divergence - regionally, sectorally, and historically - and this is a trend likely to continue so some opportunities will open up even if they are less exciting than the volatile crisis period.
The divergence from near-term history is beginning as December inflation data starts to hit the wires and challenge the assumed deflationary crisis impact. The steep declines in oil prices at the end of 2008, which drove steep declines in the monthly and annual rates of headline inflation through January 2009 is now out of the data. Headline inflation is rising in most major economies, and is likely to exceed the 2.0% annual pace that most central bankers have as their target.
This will complicate the monetary message, but is not a direct concern for most central banks. Past inflation does not drive monetary policy, expectations of future inflation do - and expectations of core inflation are what matters, not headline. For most advanced economies, core inflation will be held in check by high unemployment rates and muted pass-through from commodity prices (See TD Securities Market Musing Rising Commodity Prices: Not So Rotten to the Core).
At the other end of the spectrum is China and many other EM's, where slack in the economy is negligible to nonexistent, inflation is less well anchored, and tightening will continue to come sooner. China's recent announcement of higher reserve requirements signals an earlier withdrawal of liquidity than expected. It is also a sign of their continuing desire to leave the currency unchanged, and their willingness to look the other way as hot money inflows help to stoke inflation.
Inflation Risks Versus Expectations
There is a large divergence in inflation perception versus reality. The spread between various national breakeven inflation rates and actual lagged CPI outturns continues to be wide, even when compared against our forecasts for consumer inflation rates.
The inflation risk premium, rather than just the simple expectation for inflation, has become a strong driver of breakevens. The US five-year, five-year forward break-even now sits at 3.2% compared to about 2.5% prevailing prior to the financial crisis.
Current inflation, production, and labour hiring drive inflation expectations, but the risk premium is driven by uncertainty and the volatility of each of those measures. When you hit a pothole, the ebb and flow of the shock is only partly dissipated over time. Similarly, the sharp decline and resurgence in inflation rates and economic growth is itself increasing the risk premium around inflation. This positive feedback loop worked in central banks' favor in the Great Moderation, but the negative feedback loop will now complicate matters during the Great Transition. We can look to the U.S. economy now tracking a near 5% growth rate for GDP in the fourth quarter of 2009 as yet further evidence that this inflation uncertainty premium will remain sticky.
Central Banks in the Transition
The return of country-specific risk and a sticky inflation risk premium may not have deleterious effects, but they will reinforce central bank divergence. The Bank of England seems most at risk on this front. Mervyn King will almost definitely be writing a Dear Darling letter once the January data is published - the central bank Governor in the UK must send a letter to the Chancellor of the Exchequer any time consumer inflation exceeds 3%. It also looks likely the inflation rate will remain elevated through much of 2010. Add in ongoing upside surprises on inflation driven by the sterling's depreciation - and our expectation that the currency will continue to underperform - and U.K. inflation expectations seem most at risk of drifting higher.
Oddly enough, the U.K. also joins the U.S. as central banks where there is still some risk, albeit small, that policy could still be eased further in the near-term. Both have members on the inside still inclined to ease rather than tighten policy and both have investigated means of better anchoring the short-end of the curve in the interim between the end of QE and the start of interest rate hikes. This may be good for stoking economic growth, but could further aggravate general market discomfort with inflation expectations and continue to stoke inflation and economic growth with a weaker currency.
Then there are the areas where the risks around inflation seem more balanced. The country-specific risk for Canada is not measuring the amount of total monetary tightening, but rather deciding exactly how much of it will come via the currency versus higher interest rates. The Canadian dollar's strengthening against the U.S. dollar is coming about a quarter later than we expected, but continues to show signs that it will breach parity - and we expect the CAD sustain a level above parity throughout this year - constraining interest rate tightening to a minimum.
Existential Postcards from the Edge
The most apparent divergence recently has come at the hands of rating agencies. Greece, Ireland, and Iceland continue to have the most pressing concerns, while the U.K., Spain, and Portugal have all been placed on the near-term radar. Japan and the U.S. will continue to drive some angst in the markets, but at least for the time being, rating agencies have continued to cite their special role in the global economy and relationships with investors as keeping their ratings stable. A U.S. ratings downgrade is unlikely if at all for many years, and at least a couple years off for Japan, as well.
The European existential angst comes from running a sixteen speed economy with only one policy tool. If there was real labor mobility across borders or one fiscal authority issuing debt, with German taxpayer money supporting Greek borrowing, equilibrium would be more easily achieved. But as it is, the ECB can never raise interest rates high enough to slow the peripheral economies during the good times, nor can they take rates low enough - or keep them there long enough - to sustain them during slack times.
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Monetary policy in the Eurozone has typically been driven by the EZ3 - Germany, France, and Italy - and this is unlikely to change, so higher interest rates will exacerbate the problems of Greece, et al. Moreover, the Eurozone policy of providing unlimited 12-month tenders to banks has ended and shorter maturities are set to be wound down.
Much of this credit has found its way into the higher-yielding Euro markets like Greece, keeping spreads off Bunds less than they would otherwise be - and will now contribute to higher borrowing costs for these higher yielding markets. Moreover, the direct threat for Greece is that their Moody's rating remains just two notches away from disqualifying their bonds to be used as collateral for ECB borrowing. If Greek actions do not match their promises to date, and unfortunately the history here is on the side of fiscal slippage, the cost of Greek borrowing could see a sudden increase.
Relativity Returns to Markets
Economic recoveries may be banal, but this hardly means they are without opportunities. Diminished currency volatility and more conviction of widening interest rate differentials across countries have driven the attractiveness of carry trades. The productivity spurt and massive job cuts in the U.S. still sit as a potential factor that could drive the U.S. growth to outperform consensus to a larger degree than many other majors, especially Europe. And even this is a battle of the also-rans when compared to emerging market economies that are running faster and increasing rates sooner. Relativity is returning to markets.