Connect with us

Business

Analysis-On inflation, central bankers shouldn’t take market’s word for it

Published

on

November 1, 2021

By Francesco Canepa and Balazs Koranyi

FRANKFURT (Reuters) – Investors are pricing in the briskest inflation rates in decades for the United States and the euro zone but central bankers may be well advised to take that with a pinch of salt given flaws in the indicator.

The so-called five-year/five-year forward gauge of market inflation expectations – or 5y5y for short – has hit 2% in the euro zone and its U.S. counterpart is even above that threshold, which is the Federal Reserve’s and the European Central Bank’s goal.

Advertisement

So should both central banks just declare victory and begin raising rates?

Not so fast.

Both indicators, which roughly measure how much compensation investors demand to take on inflation risk over a 10 year period, are marred by flaws.

For starters they have a poor track record of predicting inflation while they have an uncanny correlation with movements in oil prices.

This beats economic logic since one measure is the price of a barrel of crude to be delivered in short order while the other is a long-term rate of change in overall prices.

Advertisement

The correlation may have to do with the internal working of financial markets, where some investors use inflation-linked products to hedge other trades.

“Would the 5y-5y be a good predictor of future realised inflation? I don’t think so because it correlates to oil futures, which are bad predictors,” said Ilia Bouchouev, a managing partner at Pentathlon Investments and a lecturer at New York University.

His firm belongs to a niche of hedge funds that seek to exploit that correlation by simultaneously trading oil futures and inflation swaps when their price diverge.

In addition, the low trading volumes in the swap contracts underpinning the European 5y5y mean a relatively small number of traders can influence its price, which can also be distorted by general market turbulence.

The ECB has long been aware of these and other limitations.

Advertisement

It warned as early as 2006 that the inflation swaps “should not be interpreted as direct market expectations of future inflation rates” and concluded last summer that “market imperfections” accounted for 30 basis points in a 100 basis points fall in the 5y5y since 2008.

The U.S. 5y5y was no better. Unlike its euro zone peer, it is based on the so-called breakeven rate – the spread between the yield on inflation-linked Treasury bonds and their nominal counterparts.

With the Federal Reserve owning almost a quarter of the Treasury Inflation-Protected Security (TIPS) market and over a fifth of the underlying Treasuries, some investors feel that the 5y5y was losing importance as an indicator.

“Pricing on breakevens to some extent is somewhat controlled which to me implies it’s an imperfect mechanism to either get a gauge of what true market inflation expectations are or indeed to perfectly hedge against inflation,” Sonal Desai, chief investment officer of the Franklin Templeton Fixed Income Group, said in a corporate podcast.

(GRAPHIC: Oil price and the ECB’s favourite gauge of inflation expectations – https://fingfx.thomsonreuters.com/gfx/mkt/egvbkmrqdpq/euro%205y5y%20vs%20Brent.png)

Advertisement

ROD FOR OWN BACK

Central bankers have made a rod for their own back.

In 2014, then ECB President Mario Draghi unleashed the market’s obsession with the euro zone’s 5y5y by elevating it as the central bank’s favourite measure of inflation expectations in a speech paving the ground for a massive bond-buying plan.

This may have contributed to the 5y5y own demise based on Goodhart’s law.

This law, named after British economist and former Bank of England policymaker Charles Goodhart and later reformulated by anthropologist Marilyn Strathern, stipulates that when a measure becomes a target, it ceases to be a good measure.

Advertisement

The ECB’s chief economist Philip Lane and fellow board member Isabel Schnabel have already started complementing the 5y5y with the probability, implied in option prices, of inflation coming in within certain ranges.

Old-fashioned forecasts by flesh-and-bone economists were also getting mentions by policymakers.

According to a Reuters poll, euro zone inflation was likely to come in at 1.8% next year and 1.6% in 2023 and 1.6% in 2024 – still not meeting the condition for the ECB to raise its interest rates, which is that price growth is seen stably at 2%.

The Fed, for its part, has even created an Index of Common Inflation Expectations that merges surveys and market prices.

Yet both ECB President Christine Lagarde and Fed chair Jerome Powell regularly cite market-based expectations, indicating their continued relevance.

Advertisement

Indeed surveys may be insulated from market turbulence but they also have their drawbacks, such as a limited sample size and relative infrequency.

“In the end all indicators have limitations so we go with the preponderance of evidence,” Fritzi Koehler-Geib, chief economist at German state bank KfW, said.

(Reporting By Francesco Canepa; Editing by Toby Chopra)

Advertisement
Continue Reading
Advertisement

Business

Yen shines, Aussie sags as Powell turns hawk despite Omicron uncertainty

Published

on

December 1, 2021

By Kevin Buckland

(Reuters) – The safe-haven yen held steady on Wednesday, while the risk-sensitive Australian dollar languished near a one-year low after Federal Reserve Chair Jerome Powell signalled a faster taper of stimulus despite the risks around the Omicron COVID-19 variant.

Investors fear that hasty monetary tightening could choke off the nascent economic recovery, with little still known about Omicron’s potential to evade current vaccine protection or how deadly it might be.

Advertisement

“Investors are staying cautious,” said Shusuke Yamada, chief Japan FX strategist at Bank of America-Merrill Lynch.

“It’s very difficult to make a judgement about the impact of Omicron when we don’t have a lot of information.”

Global markets fell sharply on Tuesday after the head of drugmaker Moderna said existing COVID-19 vaccines would be less effective against the new variant, although BioNTech’s chief executive struck a cautiously positive note, saying the vaccine it makes with Pfizer would likely offer strong protection against severe disease from Omicron.

The Aussie weakened 0.12% to $0.71245 after dipping as low as $0.7063 of Tuesday for the first time since Nov. 3, 2020. The New Zealand dollar was largely flat at $0.68195 after also touching the lowest since early November of last year at $0.6773 in the previous session.

The greenback ticked 0.09% higher to 113.26 yen, but still within sight of an overnight low of 112.535, a level not seen since Oct. 11.

Advertisement

Powell said in testimony to Congress on Tuesday that Fed officials will discuss at their Dec. 14-15 policy meeting whether to end bond purchases a few months earlier than had been anticipated. The Fed chief finally did an about face on a long-held contention that inflation would be “transitory.”

Powell expressed confidence that the impact from Omicron will be far less than in the spring of 2020, when the pandemic erupted.

In response, traders wound up interest rate hike expectations, with money markets now almost fully priced for tightening at the June meeting.

Powell’s testimony continues later Wednesday.

“Powell’s unexpectedly hawkish tone overnight, essentially asserting that inflation risk has primacy over growth/Omicron risks, should leave the (dollar index) forging ahead,” Westpac strategists wrote in a client note.

Advertisement

The index, which measures the dollar against six major peers, traded at 95.921 after sliding to 95.544 on Tuesday for the first time since Nov. 18, weighed down largely by an unwinding of bearish bets on the euro, the most heavily weighted component in the basket.

Westpac recommends buying dips in the index down to the mid-95 level.

The single currency slipped 0.04% to $1.1331, down from a two-week high of $1.1387 overnight.

Sterling traded not far from an 11-month low of $1.31945 reached overnight, last changing hands at $1.32955.

(Reporting by Kevin Buckland; Editing by Shri Navaratnam)

Advertisement

Continue Reading

Business

OPEC+ begins two days of talks amid oil rout

Published

on

December 1, 2021

LONDON (Reuters) – OPEC and its allies begin two days of meetings on Wednesday to decide whether to release more oil into the market or restrain supply amid an oil price rout and fears the Omicron coronavirus variant could weaken global energy demand.

Oil prices fell to near $70 a barrel on Tuesday from as high as $86 in October, posting their biggest monthly decline since the outset of the pandemic, as the new variant raised fears of a supply glut.

For November, Brent fell by 16.4%, while WTI fell 20.8%, the biggest monthly fall since March 2020.

Advertisement

“The threat to oil demand is genuine,” said Louise Dickson, senior oil markets analyst at Rystad Energy. “Another wave of lockdowns could result in up to 3 million bpd (barrels per day) of oil demand lost in the first quarter of 2022.”

Also pressuring prices, Federal Reserve Chair Jerome Powell said the U.S. central bank likely will discuss speeding its reduction of bond purchases amid a strong economy and expectations that a surge in inflation will persist.

The Organization of the Petroleum Exporting Countries (OPEC) will meet on Wednesday after 1300 GMT, followed by a meeting on Thursday of OPEC+, which groups OPEC with allies including Russia.

Several OPEC+ ministers, including from Russia and Saudi Arabia, have said there was no need for a knee-jerk reaction from the group.

But some analysts have suggested OPEC+ might put plans to add 400,000 barrels per day (bpd) to supply in January on hold.

Advertisement

The group was already weighing the effects of last week’s announcement by the United States and other countries to release emergency crude reserves to temper energy prices.

OPEC+ has been gradually winding down record supply cuts of 10 million bpd implemented last year and currently has some 3.8 million bpd of reductions still in place.

The increase in OPEC’s oil output in November has again undershot the rise planned under a deal with allies, a Reuters survey found.

(Reporting by OPEC team, writing by Dmitry Zhdannikov, editing by Richard Pullin)

Advertisement
Continue Reading

Business

New York accuses Amazon of backsliding over worker safety, seeks monitor

Published

on

December 1, 2021

By Jonathan Stempel

NEW YORK (Reuters) -New York state’s attorney general on Tuesday asked a state judge to appoint a monitor to oversee worker safety at an Amazon.com Inc fulfillment center in New York City, citing the retailer’s alleged rollbacks of COVID-19 safety measures that were “already inadequate.”

Letitia James, the attorney general, also wants a court order requiring the rehiring of Christian Smalls, who Amazon fired for allegedly violating a paid quarantine by leading a March 2020 protest over conditions at the Staten Island facility.

Advertisement

James, a Democrat running to become New York governor, sued https://www.reuters.com/article/us-amazon-com-complaint/new-york-attorney-general-sues-amazon-over-covid-19-shortfalls-idUSKBN2AH0C2 Amazon in February in a New York state court in Manhattan over its safety protocols for thousands of workers at the Staten Island facility and a distribution center in the New York City borough of Queens.

She said Amazon is valuing profit over safety and “acting as if the pandemic is over” by rolling back safety protocols even as the Omicron variant https://www.reuters.com/business/healthcare-pharmaceuticals/omicron-variant-could-outcompete-delta-south-african-disease-expert-says-2021-11-30 of the COVID-19 virus threatens to increase transmission rates.

The alleged rollbacks include making the Staten Island facility “mask-optional” for vaccinated workers while not requiring masks for unvaccinated workers, and failing to enforce social distancing.

In her motion for a preliminary injunction, James said the proposed monitor would oversee upgraded cleaning, hygiene and social distancing procedures.

“While case rates, hospitalizations, and deaths rise, Amazon rescinds protections and packs in more workers for its holiday rush,” James said in her motion. “Amazon’s ongoing – and worsening – failure to protect workers must be halted.”

Advertisement

Amazon said in a statement it has taken a “comprehensive approach” to COVID-19 safety.

“It’s disappointing that the Attorney General is seeking to politicize the pandemic by asking for ’emergency’ relief now despite having filed this lawsuit nine months ago,” Amazon said.

The Seattle-based company is appealing a judge’s refusal in October to dismiss James’ lawsuit.

Amazon on Nov. 15 reached a separate settlement with California https://www.reuters.com/legal/government/amazon-settles-california-claims-it-concealed-covid-19-cases-workers-2021-11-15 over claims it violated a state “right-to-know” law by concealing from warehouse workers and local health agencies the numbers of workers being infected with COVID-19.

(Reporting by Jonathan Stempel in New York; Editing by Matthew Lewis and Stephen Coates)

Advertisement

Continue Reading
Advertisement

Trending