Daily Note – Beware the outsider in calm waters


United Kingdom: BoE doing what central banks do

Eurozone: German inflation accelerates

The Week ahead: Focusing on Eurozone and US


Good morning,

For Irish football fans, watching the unfancied ten-man Costa Rica team scrape through on penalties against Greece last night, brought back memories of the 1990s World Cup when our team got to the last eight of the World Cup in Italy following a penalty shoot-out with Georgie Hagi’s Romania.  The potential to cause a shock in the World Cup is what keeps us watching. There is something magic in sport when the little guy wins or when the big guy fails – it always causes quite the stir.

The same goes for the markets. When volatility is low, a surprise move can also cause quite the stir.

In recent weeks, volatility in markets has been very low. This low volatility lulls the market, like favoured football teams, into a false sense of security and so when something out of the ordinary happens, it creates quite the shock.

I fear that the latest episode of low volatility is setting the stage for quite a market shock, the type we see when the journeymen of Costa Rica pull a fast one on the aristocrats of Holland in the next round!

But for the moment all is quiet.

Friday was a muted day in equities. The  SPX traded in a 10-point range, ultimately closing a touch stronger on the day led by tech (+0.59%).

The theme of the week was the bounce in volatility, after a number of weeks of abnormally low levels we finally have some movement. As we will discuss in more detail in coming days, I believe the abnormally low level of volatility has the potential to pose some serious dangers to financial market stability.

Consider the long-term chart of S&P 500 volatility as measured by the VIX index.

Figure 1: VIX Volatility Index

1_Daily Note 30th June 2014 - Fig 1 S&P 500 Vol

This low level of volatility is replicated in most other asset classes, particularly in fixed income.

I will come back to this in more detail in the days ahead. Remember we are talking here about shocks similar to the Costa Rican displays in Brazil.

United Kingdom: BoE does what central banks do

Outgoing Bank of England policymaker, Charlie Bean said over the weekend that the bank could begin to unwind its quantitative easing programme of bond purchases once interest rates start to rise. I should hope so, given that bond yields are at the lowest level in the UK since the 17th century!

“I think it will be natural either at the time the MPC [Monetary Policy Committee] raises bank rates, or sometime shortly thereafter to say ‘Ok, we won’t reinvest maturing gilts’” Mr. Bean told Sky television in an interview.

The BoE purchased £375bn of British government bonds between 2009 and 2012.

When the US Federal Reserve concluded their first program of QE in 2010, there was a lot of talk about the mechanism of selling assets back to the market. The reality though, as hinted by Bean above, is that no central bank will ever sell assets back to the market.

The key to understanding central banking is that the central bank can do what it likes. This is something market commentators don’t understand. As a former central banker, I realize that this is the alchemy of the central bank. It doesn’t have to play by the rules. It can make them up as it goes along.

In the case of the UK, the BOE will not sell assets back to the market. It will simply stuff them in its portfolio and forget about them. It is in effect, a deal between two parts for the UK government. The Treasury pretends to sell bonds to the Bank of England and the Bank pretends to worry about it!

So there is no need to worry about rates rising as the Treasury looks for new buyers for all these bonds because the central bank will never sell. It’s not the same as you and me.

Eurozone: German inflation accelerates 

Table 1 30 JuneOnly a month ago the market was obsessed with EZ inflation data being too low, yet Friday’s German data showing higher prices, not lower prices passed off with little or no comment.

German harmonised inflation rose from +0.6%yoy in May to +1.0% in June (see chart below).

Figure 2: German CPI YoY %

2_Daily Note 30th June 2014 - Fig 2 German CPI

This reading was well above the consensus expectations (Cons: +0.7%yoy) because the fall in the euro and the rise in commodity prices, particularly oil, are pushing up imported inflation in Germany. We have long maintained that higher energy prices have the capacity to slow economic growth. We will have to see if the energy price increases reflected in these numbers has a pass through to economic growth.

Figure 3: Crude oil priced in Euros

3_Daily Note 30th June 2014 - Fig 3 Crude Oil In Euros

This inflation surprise in Germany is partially balanced by Spanish inflation data (released earlier), which is still edging down more than expected, by 0.2pp to 0.0%yoy (Cons: +0.1%yoy).

The Week ahead: Focusing on Eurozone and US 

Table 2 30 JuneIn a shortened trading week due to the US July 4th holiday on Friday, the focus remains both the US and EZ economies.

We expect strong US jobs growth (con 215k) and a declining unemployment rate. This is likely to support our view for the USD to outperform most other currencies in coming months particularly against the Euro. Our bullish USD and higher US rates views are built on a continuing economic recovery, tightening labour markets and a significant rise in inflation versus Fed forecasts that forces the market to re-price the medium-term path of the fed funds rate.

In Europe, we expect limited information in Thursday’s ECB meeting following the vast array of measures announced at the June meeting, though President Draghi is likely to maintain his dovish tone and be quizzed further in the post-meeting press conference.

Ultimately, we believe the ECB has done enough to stop the decline in medium-term inflation expectations.

Figure 4: Spread between US & EZ 3 month bank rate + The Euro FX

4_Daily Note 30th June 2014 - Fig 4 US vs EZ 3mth + Euro FX

Table 3 30 June

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