-    US producer price inflation probably rose above 2% in June (13.30 BST)

-    Bank of Japan may yet announce even bolder monetary easing

-    Bank Indonesia hikes again

 

Key Market Themes

The Treasury market has reacted warmly to the publication of the minutes of June’s FOMC meeting (see US section below), with the 10-year yield dropping back to around 2.6%. Although there was little in the minutes to dispel the idea that the Fed will begin to scale back its asset purchases in the second half 2013, investors no longer appear fazed by the prospect of an eventual (and inevitable) gradual reduction in unconventional monetary stimulus.  This is presumably because a significant part of the boost that such stimulus previously provided now appears to have been unwound. That being said, we think the medium-term prospects for bonds are still fairly bleak.

 

Quantifying the impact that unconventional monetary stimulus has had on the 10-year Treasury yield is no easy task. One approach is to decompose the yield into two parts. The first part is the portion of the yield that reflects only expectations for short-term interest rates over the lifetime of the bond, i.e. the prospects for conventional policy. The second part is a so-called “term premium” that captures all the other factors that influence the yield. One of these is the Fed’s unconventional stimulus, which includes the central bank’s asset purchases and its forward guidance.

 

Ordinarily, the term premium on a 10-year Treasury is positive: although credit risk is generally perceived to be very low, investors tend to require compensation for uncertainty about the future path of interest rates. But between the beginning of 2011 and the beginning of 2013, the term premium collapsed and turned negative: according to unofficial estimates published by Federal Reserve staff, the term premium on a 10-year zero coupon Treasury declined from around positive 0.6% to minus 0.6% during this period. (See Chart 1.)

 

In part, this may have been due to greater demand for “safe havens”, but we suspect that the major driver was the Fed’s policy stance, as the period encompassed the launch of both “Operation Twist” and QE3.

 

Nonetheless, after remaining fairly stable through the first four months of this year, the term premium suddenly shot up in May and had all but disappeared by the end of June (the latest date for which an estimate has been published by the Fed).

 

In fact, of the 1% or so rise in the overall 10-year zero coupon yield in May and June, more than two thirds is estimated to have been due to a rise in the term premium rather than to a change in investors’ expectations about the average level of future short-term interest rates over the next decade.

 

With much of the “term premium effect” from quantitative easing now out of the Treasury market before unconventional stimulus has even been scaled back, it is perhaps not altogether surprising that investors have taken the latest FOMC minutes in their stride.

 

Yet the respite in the Treasury market may not last long. For a start, the term premium is still well below “normal” levels. And the average level of expected interest rates also seems on the low side.

 

For example, if we assume that the instantaneous expected short-term rate at the ten year horizon is a reasonable proxy for investors’ expectation of the long-run “neutral” federal funds rate, then the rate of 3.5% estimated by Fed staff at the end of June is still much lower than it has generally been in the past (despite already edging up from 3.1% or so in the spring). Our baseline assumption is that the federal funds rate will be back up at around 4% within four to five years, although we don’t expect a first hike until the first half of 2015.

 

With all this in mind, we forecast the 10-year Treasury yield to trend sideways during the rest of 2013 (our year-end projection is 2.5%), but then to drift up to 3% by the end of 2014 and to 3.5% by the end of 2015. And we wouldn’t be surprised if the yield was back up at 4-5% by the time the forthcoming tightening cycle was over. Of course, the Fed may seek to contain upward pressure on bond yields. But provided any rise is a logical response to its decision to tighten the monetary screws, it is hard to imagine why the central bank would be alarmed. (John Higgins)

 

What to watch for this week: US

For the first time in eight months, headline producer price inflation (13.30 BST) probably rose above 2.0% in June. (Our forecast is an increase to 2.2%, from 1.7% in May.) Almost all of the 0.5% m/m rise in producer prices that we expect would be due to a rise in gasoline prices. Data on agricultural commodity prices suggest that a fall in food prices may work in the other direction. Excluding energy and food, core prices may have risen by 0.3% m/m (prompting the annual rate to edge up to 1.8%). That would be the largest rise in a year. But since a third of it may be due to the effects of some recent tobacco tax hikes at the State level, it wouldn’t represent a strengthening in price pressures. (Paul Dales)

 

Despite the drop back in some of the timelier consumer confidence indices in early July, we think there is some scope for the University of Michigan measure (14.55 BST) to rise a bit, perhaps to above its long-term average of 85.0, from 84.1 in June. (Amna Asaf)

 

Wednesday’s minutes of the US FOMC meeting that took place in mid-June support our view that the Fed will probably start to taper QE3 in September. At the meeting, the “several” members who were keen to slow the pace of the monthly asset purchases “soon” were outgunned by the “many” who wanted to see further improvement in the labour market first. The strength of June’s Employment Report will surely satisfy those members who are more reluctant to pull the trigger.

 

This means there is a chance that the Fed will start to taper QE3 at the meeting scheduled for 30th/31st July. But the minutes also noted that “some” members wanted to see more evidence of the pick-up in economic growth they expect. As the initial estimate of Q2 GDP growth, which we think will be as weak as 1.0% annualised, will be released just hours before the Fed’s decision on the 31st July, it is likely to hold off until September.

 

The minutes did not suggest by how much the Fed will initially reduce its monthly asset purchases from the current $85bn. Nor did they suggest whether it will trim its MBS and Treasury purchases in equal measure. But in a broader discussion on its exit strategy, it noted that it eventually wants its asset holdings to be predominately Treasuries, so it would make sense to trim the MBS purchases first or by more. Finally, the minutes emphasised the distinction between tapering QE3 (loosening policy in smaller steps) and raising interest rates (tightening policy). (Paul Dales)

 

Continental Europe

May’s euro-zone industrial production figures (10.00 BST) look set to reverse April’s 0.4% rise, which would be the first fall since January. Already released national data show that production in Spain and Italy expanded somewhat. But French and, particularly, German production fell on the month. (James Howat)

 

UK

Today’s data on construction output (09.30 BST) will be the first monthly figures that are seasonally-adjusted. April’s unadjusted figures appeared to suggest that the sector was bouncing back from the bad weather in the first quarter which disrupted many projects. And the pick-up in the construction PMI to above 50 for the first time in seven months points to an improving trend. So we expect May’s construction figures to indicate that the sector has helped the overall recovery gather a little more pace in the second quarter. (Samuel Tombs)

 

Japan

As widely expected, the Bank of Japan’s Policy Board maintained its existing plans for the pace of asset purchases and expansion of the monetary base after the meeting on Thursday. The median forecast of Board members for the CPI, excluding fresh food and the effects of the planned consumption tax hikes, also remained at 1.9% for FY 2015. However, the full range of inflation forecasts for FY 2015 is still very wide, at 0.7% to 2.3%, showing that some Board members are yet to be convinced that the 2% inflation target is achievable on a sustainable basis within two years. This suggests that further easing is still on the cards, on top of that already planned.

 

Meanwhile, machinery orders (a reliable indicator of business investment) were much stronger than expected. Private sector orders, excluding ships and those from electric power companies, jumped by 10.5% m/m in May, thus reversing April’s 8.8% decline. Even these “core” numbers are very erratic, and the pick-up so far in 2013 has done little more than offset the weakness throughout most of last year. Nonetheless, there does now appear to be a decent upward trend. (Julian Jessop)

 

China

No major data or events scheduled for today.

 

Other Asia-Pacific

We expect today’s Q2 GDP figures (01.00 BST) to show that Singapore’s economy grew 1.5% y/y thanks to a rebound in the pharmaceutical sector. But we expect sluggish global demand to hold back growth during the rest of the year.

 

Meanwhile, Malaysia’s central bank (BNM) kept its policy rate unchanged at 3.0% at its meeting Thursday. Although rapid credit growth is a worry, the central bank is likely to hold off hiking rates for now. Not only is inflation very low by historical standards, but GDP growth is slowing. Overall, we expect BNM to hike rates in early 2014. (Daniel Martin)

 

Elsewhere, Bank of Korea (BoK) kept its main policy rate on hold at 2.5%, as expected. Nevertheless, with inflation set to remain weak and economic growth likely to stay lacklustre, we forecast a rate cut before the end of the year. We believe interest rates will remain unchanged throughout 2014, and that monetary policy will only start to be tightened in 2015.

 

Finally, Bank Indonesia (BI) hiked both its main policy rate and the Fasbi rate by 50bp amid concerns about the weak currency and the outlook for inflation. Consumer price inflation is likely to rise as high as 8% y/y in the coming months after the government pushed ahead with plans to scale back its fuel subsidy regime. However, the inflation spike should prove temporary and so does not justify an aggressive tightening cycle. Although Thursday’s increase in interest rates was bigger than expected, we believe any further tightening is likely to be relatively gradual. We expect just two further 25bp increases in the main policy rate this year. This would take the BI rate to 7.0% at end-2013, compared with our previous forecast of 6.5%. (Gareth Leather)

 

Other Emerging Markets

The Central Bank of Russia’s (CBR’s) rate-setting meeting is likely to be a close call. June’s drop in inflation to a six-month low and weak activity data in May have added some weight to the argument for a cut. But with inflation well above the CBR’s target range, we think policymakers will wait for firmer signs that inflation is falling. As such, we think the benchmark interest rate will be kept on hold this time, but are pencilling in a 25bp rate cut in August. (Liza Ermolenko)

 

We expect interest rates in Mexico to be left unchanged at 4.0% today (15.00 BST). Although growth has disappointed so far this year, we expect above-target inflation and concerns about the weakness of the peso to prevent any interest rate cuts. Indeed, we suspect that rates may now be left on hold until 2015 when gradual hikes may commence. (David Rees)

 

Key Data and Events

Fri 12th      -    Rus  Interest Rate Announcement

            00.00  Per  Interest Rate Announcement

            01.00  Spr  GDP (Q2 1st Est.)

            03.00  Sri  Interest Rate Announcement

            05.30  Jpn  Industrial Production (May Final)

            06.30  Ind  Industrial Production (May)

            08.00  Spa  CPI (Jun)

            09.00  Ita  CPI (Jun Final)

            09.30  UK   Construction Output (May)

            10.00  EZ   Industrial Production (May)

            13.30  US   Producer Prices (Jun)

            14.55  US   Uni. of Mich. Consumer Confidence (Jul Prov.)

            15.00  Mex  Interest Rate Announcement

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