Fed policy, Germany and gilts

The Fed left its policy message essentially unchanged yesterday. Language on the labour market and financial market conditions was more positive, but the Fed warned that strains in global financial markets continue to pose significant downside risks. They noted that higher crude prices will push up inflation temporarily, but that inflation will subsequently run at or below levels consistent with the dual mandate. Importantly, the Fed did not seek to downplay recent labour market developments or otherwise hint that it was still inclined to consider more asset purchases. We’ll see the minutes of this meeting in early April and the minutes may reveal more discussion of additional asset purchases or twist operations as the committee tries to maintain room for manoeuvre. We may suspect that the Fed’s next move will still be in the direction of more accommodative policy, despite its more constructive policy statement yesterday.

We also had the results of the US banks’ stress tests yesterday. The Fed said 15 of 19 banks would be able to maintain capital levels above a regulatory minimum in an “extremely adverse” economic scenario, even while continuing to pay dividends and repurchasing stock.

Meanwhile in Europe, whilst all the talk’s on further fiscal austerity for the peripheral Euroland economies, solving the economic imbalances of Euroland does not only rest on the periphery countries’ shoulders even if these countries have been asked to bear most of the burden. Part of the effort to re-balance Europe also has to been borne by Germany via its current account. This might be under way. Germany’s labour market has tightened – unemployment is at a generational low, and wage demands have risen sharply. The better bargaining position of unions is likely to see a break with the tradition of the last decade, when average wage growth failed to keep up with the cost of living. After an increase of 1.7% last year, average wage growth may be nearer to 3% this year and next. Against this backcloth, unit labour costs look bound to continue increasing, but this is healthy in the bigger picture, which requires re-balancing in Euroland.

The periphery has started to restore competitiveness in a painful way, and this re-balancing can only be welcome if it is not one-sided but if instead Germany contributes by fostering domestic demand and giving up some competitiveness. For Germany and the Bundesbank, this also means getting used to the idea that German inflation is likely to exceed the Euroland average, and there will likely be little sympathy from the ECB, which has to take the aggregate into account.

Stabilisation in Euroland and its periphery represent a risk for the UK gilt market. Gilts have benefited from ‘safe haven’ status as investors diversified out of Europe. This can change quickly if the rally in the periphery is sustained – and we should be increasingly wary of the level of gilt yields.

Flows into gilts in January were still positive – the BoE and foreigners were the dominant buyers of gilts. The domestic non-bank private sector resumed selling gilts. Once the BoE ends QE which we expect to happen in May, and foreigners move on (either due to stabilization in Europe or fear of a UK rating downgrade), the gilt market will lose two major sources of demand.

This situation is further complicated by the increase in crude oil prices. CPI inflation has been sticky on the downside over the last year even when crude prices were relatively stable. The recent increase in oil prices may make it harder for UK CPI to continue falling at the current pace and should also temper the appetite of the BoE to extend QE.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla