Brevan Howard March Letter: Inflation Remains Stuck In US

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unemployment rate held steady at 6.7%, but the news was better underneath the surface as the labour force participation rate rose noticeably. The early hints about final demand in March pointed to a pick-up as well. In particular, auto sales surprised to the upside, returning to the pace last seen in early 2007. After a long and disruptive winter, it appears that the economy’s momentum is improving going into the second quarter.

Inflation remains stuck near 1%. Headline prices over the last year rose just 0.9% and core prices rose 1.1%. Inflation has been held down by a combination of deflation in goods prices, easing services prices, and a number of technical factors. So long as significant slack remains in the global supply chain, there is little reason to think core inflation will return to 2% any time soon.

The Federal Reserve modified its forward guidance in March, dropping the nearly obsolete 6.5% unemployment rate threshold and adding that it currently anticipates that it will keep rates below normal even if full employment is achieved in 2016. In a puzzling development, the FOMC’s forecasts were little changed and yet the median of their rate hike expectations drifted up. At the time of the meeting, the market interpreted this move as hawkish. However, the opposite reaction greeted the Minutes, which argued that markets should essentially ignore the higher rates path. If this experience is any guide, there will be more volatility to come.


The Eurozone unemployment rate has stabilised at a high level of 11.9%. This masks a further decline in unemployment in Germany and in Spain, but an increase in France and in Italy.  The Eurozone Composite PMI dipped to 53.1 in March from February’s 32-month high of 53.3, likely indicating that the cyclical peak in growth could be near. There was some divergence in developments, as the PMI rebounded in France, while it fell in Germany and in Italy. Low inflation continues to be the main policy dilemma in the euro area. According to Eurostat’s flash estimate, euro area HICP inflation dropped to 0.5% y/y in March. This is the lowest level of headline inflation in the euro area since November 2009. The decline in headline inflation was mainly due to a sharp deceleration in food prices and a drop in core inflation, both contributing to approximately half of the overall decline. The decline in core inflation was to a large extent due to the timing of the Easter holidays this year relative to last year. Despite the March inflation data having been a “genuine” downside surprise to the ECB, the central bank took no action in its policy meeting. However, it did indicate it may take further action in the future, if needed, also in the form of quantitative easing should inflation stay too low for too long. The next milestones for the ECB will be the April inflation print, when it will have to assess the extent of the calendar effect rebound, and the June policy meeting, when the new staff forecasts will be reported.


The constant theme in the UK data is firm growth with weak inflation. Monthly business indicators over the past months have stabilised at high levels or eased back slightly, but have generally remained resilient. Consumer confidence has risen back to pre-crisis levels, retail sales growth has continued to be robust, as have car sales. Unemployment claims data point to ongoing improvement in the labour market, consistent with above-trend growth. While some moderation in growth in the next few quarters is likely, the data thus far have been resilient. The composition of growth is also becoming more balanced, which reduces the risk that it will fall back sharply. First, investment is making an increasing contribution to growth, and with investment intentions at cyclical highs this strength looks set to continue at least in the near term. Second, with inflation falling further below target but some increase in wage inflation due to a stronger labour market, real household incomes are set to rise. While consumption growth has slowed somewhat from its high pace in mid-2013, these real income developments are likely to put consumption growth on a sounder footing for 2014. External rebalancing remains a more distant prospect, as this relies on Eurozone demand improving by more than currently seems likely. Inflation remains benign and continues to surprise the Bank of England (“BoE”) on the downside. Inflation is expected to remain below target for the remainder of the year. Wage inflation, on the other hand, shows some early signs of improving from its historical lows. As the year progresses, wage inflation is anticipated to normalise further.

The BoE announced in February that there would be no further quantitative guidance once the 7% forward guidance unemployment threshold is reached, likely within the next few months. Instead, the BoE has announced its intention (but not commitment) not to hike in the near term, to hike only gradually once hikes start, and to a level well below historical estimates of the neutral rate.


Japan is working through two big spring events: the wage negotiations and the consumption tax increase.  Following unusual protracted political attention, major corporations announced their initial offers to raise base wages, in most cases for the first time in several years.  The initial offers from the likes of Toyota were not eye popping, although by the time negotiations wrap up they should set a backstop for inflation expectations and provide a partial offset to the consumption tax hike.  Sales taxes were hiked by 3 points to 8% on 1 April. Recent survey data suggest a moderate bump in activity in advance of the tax hike and fears of at least a temporary slowdown thereafter.  More respondents reported favourable conditions relative to unfavourable conditions in the first quarter than at any time since the early 1990s.  On the other hand, the diffusion index for future conditions fell back.  The Shoko-Chukin survey of small and medium enterprises dropped sharply for April after a spurt in March.  With the consumption tax hike more in view, household confidence dropped in February to a level below that seen before the Government announced its intentions to pull the country out of deflation. Price inflation continues apace, but prices have not evinced a further acceleration.  On a seasonally adjusted basis, core inflation (excluding fresh food prices) has averaged about 0.1% per month for a while now, and western core prices (excluding all food and energy prices) has been trending at about half that rate.  By all accounts the inflation impetus from the drop in the yen over early 2013 has played out.  Year-on-year rates continue to improve due to base effects, but those gains will not continue unless monthly rates pick-up.  Policymakers are banking on a shrinking output gap to propel inflation toward its 2% target.  There are scattered reports of labour shortages starting to push up wages, though this has yet to show through to the consumer price data.

As with the economy, the market is in waiting mode with respect to structural reforms.  Watchers generally expect several reforms to be implemented, but there has been little progress to date.  Japan announced some changes to its Government-run pension fund such as allowing more investment strategies and hiring some different outside managers.  But, it is anticipated that there will also be a major reduction in the share of assets invested in JGBs and an increase in the share of assets invested into equities.  An expansion of tax-favoured investment accounts is also expected, which should also serve to boost domestic investment in equities, though the relevant laws have not been enacted.  Analysts expect the Prime Minister’s office to propose legislation to cut the corporate tax rate, which is high by OECD standards, but that legislation is not expected to be proposed until later this year.


January and February data pointed to a significant deceleration of growth in the first quarter of 2014. Top leaders, including Premier Li, have made public statements on several occasions regarding the importance of protecting growth within a reasonable range. So far, the pro-growth measures announced were restricted to accelerating the existing infrastructure projects in the pipeline, as well as securing financing of priority projects. PPI remained in deflation and both the HSBC PMI and the official PMI pointed to a further slowdown in March. Note that the headline official PMI saw a slight improvement of 0.1, but was purely due to seasonality. Therefore, if seasonality is excluded, the March official PMI points to further weakening of the manufacturing sector.

In the first two months of the year, retail sales growth slowed to 11.8%, partly due to the anti-corruption campaign, industrial production to 8.6% and Fixed Asset Investments to 17.9%. After a large front-loading of credit in January, total social financing eased in February. The largest drop is due to new loans, mostly explained by the slowed lending during the Chinese New Year. Trust loans and corporate bond issuance are

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