Dude, where’s my potential?

Last week was pretty eventful in terms of central banking. Obviously, the folk from the ECB grabbed a lot of headlines with their relative optimism but they are not the only ones trying to “whisper the reality”.

Meanwhile, two important emerging markets central banks decided to cut rates last week. And dramatically so. First, the National Bank of Poland decided to reconcile the market split between a 25bp cut and a no-change decision by… slashing rates by 50bp*. Two days later, the Banxico decided to do a similar thing, also exceeding the market expectations. Now how is that possible? Two central banks, which historically have been quite hawkish and have kept rates generally high have suddenly decided to get adventurous?

Let’s start with the NBP. Today the central bank revealed the details of its latest macroeconomic projections (a neat presentation can be accessed here). I found this chart quite interesting:

pl_potential

It shows two things. Firstly, according to the NBP models, potential growth rate has declined to below 3% from close to 6% before the crisis. Secondly, the lost output is so huge that the central bank expects the output gap to remain wide open at least until the end of 2015. In theory, that means at least two more years of zero underlying inflation pressures (caveat: see the Intermission section that follows). This is bold.

Intermission: Here I need to remind you of a significant distinction between potential output and potential growth rate. Have a look at the chart again – expected growth will exceed potential growth rate already at the beginning of 2015 (which by the way is pretty far off!). Only since then will the negative green bars start becoming smaller, reflecting the catching up with the lost potential. I don’t have a definitive answer to that but it is not entirely obvious that underlying inflation can start going up with green bars in the negative territory.

Now let’s move to Banxico. In the statement following the last meeting the central bank enumerated “structural advances” which have been made in recent years (translation here). They include:

  1. the reduction in the level, volatility and inflation persistence (ok, ok, that’s just an “idem per idem” argument)
  2. the fact that the various episodes of price adjustments have not resulted in second round effects
  3. the anchoring of expectations inflation, and
  4. the significant decline in inflation risk premium.

Of course Banxico is trying to make a big success out of it by saying that it has fostered an environment with less economic uncertainty. And good for them but someone cynical could say that this simply means that the economy has lost a significant part of its potential growth rate. I am not questioning the decision itself – I actually think the Mexicans did the right thing – but wider ramifications of it could eventually lead to even lower rates than now. Same as in Poland.

As I was thinking of the whole concept of potential growth rates in emerging economies I came across this very good article from Valor via Brazilian Bubble: Brazil’s Central Bank is in search of lost credibility. I don’t necessarily agree with everything that’s been said there but have a look at this paragraph:
Now, Brazil is not in a crisis, despite the fact that GDP has been showing subpar growth over the last two years and is on its way to perhaps the third year of such a situation. Despite that, everything indicates that the Copom is preparing to raise the Selic rate, repeating the standard reaction of a past that everybody thought had been left behind.
I can see where the Copom is coming from. Inflation remains of paramount importance in Brazil, to the point that they publish data to second decimals, as if it had any macroeconomic implications. I am not sure whether hiking rates will be the correct decision but I wanted to point out what can happen to an emerging economy if potential growth rates decline. If the economy has been showing “subpar growth over the last two years” and inflation is surging then maybe it wasn’t “subpar growth” after all?
There are of course positive examples, too. Turkey is one of them (although not very recently). I have not been in agreement with their recent policies and I think they’re throwing their undisputed success in fighting inflation to the wind but if we go a bit further back, we will see at least two episodes of a durable decline in the inflation rate. Both occurred after periods of significant economic hardship – first at the beginning of the millennium and then after the 2006 crisis. Now, Turkey had a grand opportunity to durably lower inflation after the 2008/09 global crisis but the central bank instead decided to focus on micromanaging pretty much every element of the economy. The reason I mention that is all three episodes of a shock to let’s call it “normal” level of inflation were used by the central bank to slash rates dramatically. In this respect, the CBRT recognised that the economy has become less inflationary. However, it remains to be seen whether its most recent response to global events is correct. In other words, the risk the CBRT is running is that it assumes that potential growth rates is higher than it actually is. It worked in the first two instances but that may be because they were driven by local developments (rather than the global crisis like in 2008/09). If the CBRT is not lucky this time, events could necessitate a similar approach to the Copom.
How to trade this? There seem to have been two approaches to monetary policies in recent years in emerging markets. On the one hand, we have seen activist central banks such as BCB or CBRT which have actively engaged in currency wars etc. They seem to be operating under the assumption that they need to counter whatever it is that Fed/ECB/BoJ conjure. I would call that “externally driven monetary policy”. On the other side of the spectrum you have the likes of Poland or Mexico, which – while acknowledging the impact of external developments – have maintained their reaction functions roughly unchanged. The latter group is beginning to realise that their economies are developing considerably slower than they could and so chances are that last week’s rate decisions are not the last surprises they have for us. As such money market curves should steepen there. The former group is to some extent the opposite. They are either like Brazil coming to the conclusion that inflation is becoming an issue despite slow growth. Or, like Turkey, they keep playing with fire pretending that the economy is still not strong enough to push inflation higher. One should be very careful being long duration in those, in my opinion.

* Despite huge temptation, I will not dwell on how ridiculous the communications policy of the Poles is. After two months of becoming increasingly more hawkish and suggesting a pause, they decided to cut more than expected to show that they’re done. I did not lose money on that so it’s not my grief speaking but I really believe this is the worst Monetary Policy Council among the mainstream emerging countries.

Inflation volatility or which bond markets to avoid

As promised, a quick word about inflation linkers in emerging markets.

While in most cases, the path of inflation in the coming 3-6 months is pretty much given; many economies are a completely different level of their respective inflation rates. Importantly, volatility of inflation rates also differs wildly. Take the following chart as and example. It shows the relationship between average inflation since the beginning of 2005 (so around 100 observations) and the standard deviation of CPI in the same time-frame.

cpi_vol

As you can see, there is a group of emerging economies which have achieved a relatively low level of inflation (the circled part of the chart) but they have had mixed success in terms of staying close to the average. Arguably, Israel, Malaysia and Poland are the best in this field.

As you move to countries with higher average inflation rates, standard deviation tends to rise. However, note that we are talking here in percentage points, as opposed to normalised values. In other words, we say that Poland is “better” than Turkey just because it has had a lower average and a lower standard deviation. However, if you normalised standard deviation by dividing it by the average you will see that Turkey has been much closer to its average than Poland. We will use that in a minute.

The chart below combines the approach of the volatility in inflation rates (i.e. standard deviation divided by the average) with the distance of the latest CPI print from respective central banks’ targets (note that for some countries I had to make assumptions as their central banks are not inflation targeters).

cpi_vol2

In this chart we see, for example, that South Africa is 1.2pp above the 4.5% target (mid-point of the 3-6% SARB range) and  that standard deviation of CPI prints since 2005 has been around 40% of the average (which was 6.1%).

How to trade this? Someone could ask what the point of looking at such a chart is. Well, as worries about inflation resurface along with some acceleration in growth rates, investors will be willing to bet that some emerging economies could have their inflation rates moving up fast. At the same time, the central banks would have to respond. Therefore, I think that what we’re looking for is countries, which

  1. currently have inflation below (or close to) the central bank’s target
  2. have experienced significant volatility of inflation prints in the past.

In those economies you should consider looking at inflation linkers or shorting nominal bonds.

When using such a comparison, Chile stands out as a good candidate with low current inflation and high inflation volatility. Similarly, Israel has a history of quite rapid moves in inflation rates and we also can be reasonably sure that the output gap there is insignificant. Finally, Poland is looking at rapid declines in inflation rates at the moment, mathematically increasing odds of a rebound in the second half of the year and indeed in 2014.

There are also many caveats to this approach but I have found it to be a useful starting point when trying to play a global inflation / disinflation theme.

Those boring oil prices

Econbrowser ran a post entitled “Dude, where’s my cheap gas?“. It has a few interesting charts indicating that it will take some time before the shale gas/oil revolution impacts prices at the pumps. I think there could be a bit more into that story and quite soon, too.

The chart below shows the spread between Brent and WTI oil prices.

brent_wti

This has stayed elevated for quite some time and for various reasons and it seems to me that the market is no longer paying attention to why this is actually happening. Many have been citing he Middle East turmoil as one of the reasons. While this is certainly a factor, why would we see that only in Brent prices? Firstly, Brent and the Middle East blend are not exactly substitutes. Secondly, we are not seeing that risk in any other market (have a look at the Israeli shekel or forward points in USD/SAR in Saudi Arabia). Finally, there is tons of new supply coming from Iraq and some African nations, replacing the lost output from Iran. In short, I don’t find the whole Middle East hypothesis plausible.

So if it’s not supply disruptions/changes then maybe it’s demand? If you go through the Chinese data (and seasonally adjust them), you will find that the dynamics is pretty decent. Moreover, for years everyone has been talking about Chinese urbanisation, which inevitably brings more demand for fuels (think of it as the copper-oil spread). We can’t be certain how far advanced in the process we are but things are progressing in the direction of less investments and more consumption.

Meanwhile, the world is fixated on declines in inflation, which are about to happen or are already happening. Have a look at the momentum in US core inflation (below, annualised rates).

us_cpi_momentum

There is almost nothing worrying about this picture unless of course you are a firm believer in the “what goes down, must go up” theory. In all likelihood the US inflation picture will not change in the coming months, particularly in the core. But what about the rest of the world?

Let’s not forget that vast majority of economies have experienced a significant drop in potential growth rates over the last couple of years. This means that any increase in growth could lead to inflation sooner than we think. Sure, many will say that it’s not just the growth rate that matters and we need to close the output gap first but the worry is that the world where productivity is on the decline any growth acceleration could be inflationary. Add to that a sustained supply shock and you have a recipe for a pretty decent repricing of interest rate expectations.

Now, I don’t mean to sound alarmist about inflation and I would not call myself a vivid supporter of people who call for repetition of the Weimar Republic (yes, Ambrose Evans-Pritchard, I’m talking about you…). But the prevailing way of thinking is that many countries will not need to hike interest rates for longer than you would normally expect simply because the additional carry would strengthen their currencies. This is particularly the case in emerging markets. The same emerging markets, for which the growth consensus remains pretty bullish…

Where does this leave us? Improving leading indicators, lower potential GDP growth rates, reduced productivity growth and possibly quite persistent upward trend in oil prices. For me these are crucial reasons to worry about bond markets in many (emerging) economies. In my mind they are certainly more valid than the US Treasury sell-off cliche, which dominates media and analysis.

How to trade this? Find a country with a significant trade deficit and improving growth outlook (e.g. Turkey) and be defensive there. Also, look for activist central banks (e.g. Israel) and be aware that those guys can and will move very quickly. Additionally, if you need to own bonds, go for short duration in higher yielders (such as Russia or Brazil). Finally, think if it doesn’t make sense to switch out of suppliers or industrial materials into energy producers – this could be a very long term trend, unless of course someone comes up with a car that runs on water. And by the way, I would like to wish that last bit to all of you (unless you’re a Russian oligarch).