In this research note, we briefly review macroeconomic and financial market developments in a number of major economies, and reach two broad conclusions. First, one should take care not to overstate the extent to which the US and the UK are going through broadly similar economic recoveries. Any similarities are largely superficial, and we see no good reason why policy makers at the Federal Reserve and at the Bank of England should be expected to follow similar strategies. Second, financial markets are not priced for a policy of full-blown, unsterilised QE in the euro area - at least not of the kind that we expect. Consequently, we see further downside risks to euro area sovereign yields, and particularly those on Bunds.
The US and the UK - same but different
Most official forecasts see both the US and the UK economies growing by around 3% this year. Our forecasts suggest that the US will outperform the UK, but only by a small margin. According to both the IMF and the OECD, the UK has a slight edge. Central bank officials in each country are making near-identical statements about monetary policy. To paraphrase only slightly:
"Now is not the time for a tightening of policy, in the conventional sense of the word. When the official rate of interest does rise, it will do so only gradually. And it is likely to remain below its long-run average rate for some time to come".
At first glance then, the economic backdrop to monetary policy in the US appears broadly similar to that in the UK. Current market pricing suggests that the Bank of England is expected to move first, with a 25 basis point tightening fully priced in by April 2015. An increase in the Fed Funds rate of that magnitude is thought likely by September 2015.
But when it comes to setting monetary policy, the rate of economic growth is only one side of the coin. What matters for inflation is the level of output relative to potential. Referred to by many as the output gap, and by the Bank of England's MPC under phase 2 of its forward guidance as 'economic slack', it is a measure of the balance between demand and supply in an economy. From the perspective of economic growth, the US and the UK may look similar. But that similarity is superficial. Lift up the bonnet, or indeed the hood, and the engines powering those economies are very different indeed.
When it comes to driving sustainable economic growth, productivity is everything. In the US, productivity has risen more than 10% since the crisis hit at the beginning of 2008. In other words, it has risen at near-normal rates. In the UK it has fallen almost 5%. That is why growth of 3.1% over the past year in the UK has been accompanied by big gains in employment and big falls in unemployment. With output per worker broadly constant, spare capacity has been used up rapidly. In the US unemployment has fallen too, but for very different reasons. The bulk of the decline in US unemployment has been driven not by rising employment but by falling labour force participation. The fall in US participation has been in part a consequence of an ageing population, and in part a response to the downturn, as people gave up looking for work in the belief that none was available. As we set out in a News in Charts article earlier this year, the usual cyclical decline in participation has not taken place in the UK.
Alongside the productivity data, the contrasting behaviour of labour force participation, particularly among prime age groups, is just one more example of how, despite superficial similarities, the US and UK recoveries have in fact been very different. The UK output gap has closed, in our view, and further above-trend economic growth will put upward pressure initially on wages, and ultimately on prices. That is why, in the absence of a policy response, we see UK inflation close to 3% by December 2014. The US, by contrast, retains a considerable degree of slack. We see US inflation holding steady at a little under 2% for the remainder of this year.
As we move through the second half of this year and into the next, the pressure for the MPC to tighten will intensify. But as we have set out before, it will not deliver, at least not by enough to keep inflation under control. To find out why, look no further than the housing market. We have seen double-digit gains in house prices in both the US and the UK in recent months. But in levels terms things look very different. In the US, prices are still some 20% below their peak. In the UK they are already 5% above. Against this backdrop, a tightening of UK monetary policy, of the kind that would be warranted in more normal times, would almost certainly provoke a significant correction in UK house prices. And, with more than two thirds of UK borrowers on variable rate mortgages, a significant number of UK households would face repayment difficulties. Indeed, using Bank of England data, we estimate that a 200 basis point tightening would push the proportion of borrowers who are 'stressed' back to pre-crisis levels. In the words of outgoing Deputy Governor Charlie Bean: 'It is a brave central banker who would deliberately induce a recession in order to head off the mere risk of a future financial correction'. Speaking earlier this week, the Deputy Governor was referring to the period through the early 2000s in the run-up to the crisis. But his words apply just as well to the situation in which the UK finds itself today.
It is hard to understand why the link between US and UK sovereign yields has, if anything, intensified over the past year. Despite superficial similarities, the US and the UK economies are in very different places. From a standard inflation-targeting perspective, the need for a policy tightening in the UK is much greater. But the MPC will not deliver, at least not by enough to keep inflation under control. Consequently we see the spread of conventional gilts over US Treasuries widening, particularly through next year, not because of higher real rates of interest, but because of higher inflation expectations. And we see sterling falling sharply against the dollar.
ECB ready to loosen, and perhaps by more than markets are expecting
Back in January, we made a call that the ECB would enact a policy of full-blown, unsterilised QE before the end of this year. Our motivation in making this call was not the subdued nature of the recovery across the single currency area, but rather the fact that continued low rates of inflation would threaten debt sustainability in a number of major economies. Something needed to be done.
At the press conference following the May policy meeting, and with reference to the merits of loosening policy still further, ECB President Draghi said that the Governing Council was 'comfortable with acting [in June]'. Some form of action at the next policy meeting now seems inevitable. But what sort of action? As our implied policy rate chart shows, a 10 basis point cut in both the main refinancing rate and the deposit rate is more or less fully priced in. But what of QE? Bund yields have fallen steadily this year, and they fell sharply after Mr Draghi's comments on 8 May. But this decline has been matched, more or less step-by-step, by a decline in equivalent maturity OIS rates. In other words, Bund yields have fallen, but only because the policy rate of interest set by the ECB is expected to remain lower for longer.
If the ECB were to begin a policy of large scale asset purchases that involved buying a large number of German government bonds, in addition to private debt instruments issued by residents of other euro area economies, then the Bund - OIS spread ought to narrow significantly. The fact that to date it has not suggests to us that the market gives little or no weight to the prospect that a QE programme, of the kind that seems most plausible to us, will be announced next month. A 10 basis point cut in both the main refinancing rate and the deposit rate is priced in, but that is where it ends. Given the very real prospect that the ECB will launch an asset purchase programme, perhaps as early as next month, we see further downside risks to euro area sovereign yields, and to Bunds in particular.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: Alpha Now at Thomson Reuters is a team of expert analysts that are constantly looking at the financial landscape in order to keep you up to date on the latest movements. This article was written by Fathom Consulting, independent commentator and analyst. We did not receive compensation for this article, and we have no business relationship with any company whose stock is mentioned in this article.