Insight strategy update

Matthew Merritt, head of strategy, Insight Investment, comments on economic conditions: Recent developments in financial markets reflect heightened inflation sensitivity. The rise in energy prices is impacting on headline inflation and central banks are wary of this filtering through into core measures.

Certainly some measures of inflation expectations are rising and anchoring these expectations is a key policy goal. The ECB has again taken the lead in enforcing its inflation fighting credentials when, at its latest policy setting meeting, it indicated its intention to raise interest rates irrespective of indications of moderating growth. Since then, Bank of England and Fed officials have been using public speaking engagements to reiterate their determination to keep inflation at bay. For example, Fed Chairman Bernanke has suggested the ‘risks of a substantial downturn to the economy have diminished' implicitly raising inflation fighting as a priority goal.

The reaction in the bond markets has been extreme. Yields on 2-year notes were up 54bp in 5 days in the US, 43bp in the UK 43bp, and 40bp in Europe.

The rise in US two-year yields was the biggest two-day basis point increase since October 1982, although the starting level of yields was in excess of 10% at that time. The move we saw in week commencing 9 June is a four standard deviation event, meaning that if returns were normally distributed we would hardly ever expect to see this happen - about once every 10,000 trading days or every 40 years. However, our charts of the week show that movements in bond yields are not normally distributed, and display kurtosis. This means that returns are peaked around the mean (a lot of the time yields are less volatile than you would expect) but have fat tails, meaning that ‘extreme' market events happen more frequently than expected. The right hand chart shows that moves of 50-55bps happen ten times more often than you would expect in a ‘normal' world.

In the emerging world, policy is being tightened and fuel subsidies are being removed, pushing headline inflation higher. The central bank response should be tightening policy further including letting their exchange rates appreciate. In both the developed world and the emerging this brings with it the threat of stagflation.

Both inflation and unemployment are late cycle developments but the starting point for the major economies in terms of inflation and unemployment is such that talk of a re-run of the early 1970s appears unlikely. Indeed, policy makers are acutely aware of their failings in the run-up to the stagflationary era of the 1970s and clearly are intent on anchoring inflation expectations quickly. Whether this will require the higher short-term interest rate profiles embedded in the futures curves is unclear, but it clearly pushes the downside risks to growth, most obviously in G3 and in mainland Europe in particular.