After yesterday’s shock inflation figures, it will be extremely difficult for the MPC to avoid hiking rates when it meets next month. Indeed, it is entirely plausible that the MPC will hike twice before mid-year. Consumer price inflation in the final month of the year jumped 1.0%, well above expectations, with the YoY rate climbing to 3.7%, almost double the Bank’s 2% target. Food prices played a prominent role in the latest month – seasonal food prices increased 4.0%, but the story did not end there. Higher petrol prices contributed to a 4.8% surge in the fuel and light component, while household goods prices rose 1.6% and rail fares soared 8.9%. Core inflation is now 2.9%, up from 2.7% in November.
It is no longer credible for the Bank to continue to argue that inflation is higher than it expects because of ‘temporary factors’. The main deflationary force anticipated by the doves on the committee was the supposed spare capacity in the product and labour markets. Well, idle factories are not easily restarted, and the increasing numbers of the long-term unemployed eventually lose their skills and, as such, are not easily re-employed. If there really was so much spare capacity in the economy, then why has both headline and especially core inflation been climbing over the past two years? To continue to claim that excess capacity will bear down on inflation over the next one-two years is becoming increasingly incredible.
Inflation could rise even further in the current month, reflecting the VAT increase, higher fuel costs, and the rise in travel fares. Inflation expectations have risen markedly in recent months and gilt investors are rightly starting to question the bank’s inflation-fighting credibility. A couple of small rate increases are unlikely to derail the recovery, notwithstanding fiscal austerity. The MPC can no longer afford to prevaricate.
Strong ZEW raises the odds of an ECB rate hike. The good news coming out of Germany over recent months shows no signs of relenting. In January, the ZEW’s Economic Sentiment index jumped to 15.4, well above expectations and much higher than December’s 4.3. Capital spending in Germany remains very decent, with forward orders suggesting this strength will continue for some time yet. Jobs growth is also very healthy, which in turn is providing domestic consumption with considerable impetus. Germany’s unemployment rate is now 7.5%, the lowest for 18 years. Interestingly, one half of the respondents to the survey expect the ECB to lift the refi rate in the next six months. Against the backdrop of the exceptional growth being recorded in Germany and the rise in eurozone inflation, a rate hike from the ECB is looking increasingly likely. In response, the euro touched 1.35 against the dollar overnight, a two month high.
The dollar sinks as Europe’s central banks get closer to raising rates. With both the ECB and the MPC likely to hike rates in coming months, and Asian central banks already tightening monetary policy, the dollar was very much on the back foot yesterday and again overnight as the sense grows that the Fed is still a long way from raising the funds rate. Indeed, the dollar index has now given back all of the ground that it made in the first week of the new year. Should this perception grow, namely that the Fed will lag well behind other major central banks in terms of tightening, then the dollar will likely continue to be sold.
Europe’s peripheral bond markets back under fire. Notwithstanding the euro’s very positive price action and a significant sell-off in German paper, eurozone peripheral bond markets endured a torrid time, with spreads to Bunds out by 25bp or more yesterday. If peripheral bond markets continue to underperform like this, then it will not be too long before the euro starts to take notice. There was no particular trigger for the sharp sell-off, other than perhaps some mild disappointment that eurozone finance officials did not agree to allow the EFSF to start buying peripheral bonds at their meeting on Monday night.
Stocks continue to reach new highs as confidence in recovery grows. European equities continued to attain new cyclical highs on Tuesday as investors grow ever more confident in the recovery and as they reallocate away from fixed income. For instance, the German DAX jumped nearly 1% yesterday to a new 32-mth high, on a day when the 10yr Bund yield rose 9bp to 3.11%. More of this type of asset allocation activity is likely in the weeks ahead, namely reducing fixed income exposure in favour of equities.
Author is a freelance copywriter who writes about forex online trading