"Riding the Roller Coaster, Standing Up with Your Arms in the Air"

The markets aren't actually like a roller coaster, it's just if you let your emotions get the better of you (which is fatal), they can just seem exactly like it. There is of course a good reason for this; the numbers that everyone relies upon to make their decisions have an inherent uncertainty built into them. This is both statistical and because nothing ever goes in a straight line (except light, but that can be bent on space-time surface that has been bent by gravity… but that's another story).

We have seen in the past two days examples of this uncertainty. First of all, UK inflation numbers came in higher than everybody expected, while U.S. inflation numbers came in somewhat lower. The reason for this can be structural but also, since there are some very volatile elements within those numbers, somewhat systematic. For instance, unless something that was very pricey a year ago has risen yet further, it ceases to contribute to rising inflation. As time passes this actually has drag on the numbers. This is the so-called rebasing effect.

The interesting point is that knowing this kind of thing can happen, it is possible to wind time forwards and watch how the rebasing effect impacts the numbers. Sometimes this can be dramatic. Take for instance the U.S. (see first illustration), over the summer months of 2007 an inflationary push could become a deflationary pull downwards (a bit like gravity). In other words, no matter what the inflationary tendency at the time, there will be an opposing force on the other side that will partially, if not wholly, negate matters. The inflation numbers could easily come in lower than many people expect. This could be very useful for the U.S. Federal Reserve Open Market Committee; if there is any weakness in the economy around this time then the way would be clear to start hinting at rate cuts. At the same time the bond markets would have their path cleared to lower yields since the threat of inflation would be the least of their worries. Notice though, that by the end of the year this window of opportunity could have all but gone and by November there is a +0.5% push on inflation. In the meantime, it might be best to take out our underweight duration position in the U.S.

The UK Bank of England interest rate setters have no such luck (see second illustration). There are no rebasing effects to help them out and, as we have seen, there are factors keeping the inflation numbers above the 3% upper threshold set by the government. In that case, Interest rates are all but certain to rise in the UK in coming months.

The other obvious candidate for this analysis is Japan (see third illustration). Yet again, there are no real benign effects to help policy makers out. It could be argued that the dip in inflation will stop the Bank of Japan from increasing interest rates during the summer but, as the year progresses, there is a definite inflationary push to the numbers that emerges. By the end of the year, this is substantial and could add as much as 0.8% to inflation. Imagine a member of Bank of Japan, on the brink of retirement, and desperate to normalise interest rates on their watch; this could be very convenient and as good a reason as any to push through a rate rise no matter what the politicians are saying about who is in control of the economy.

So, if we were to think of the rhythm of things over the coming months it might look like this. The U.S. will have an opportunity to cut rates if they deem it necessary but, as we have pointed out in a previous piece, they may choose to let a decline in the dollar do the work for them. The UK and Europe will stay on a tightening bias throughout the rest of the year while in Japan, their dramatic return to the Central Bank interest rate party of normalising interest rates will probably follow the U.S. until the fourth quarter of the year. They will then be able to break away from the rest of the world. It is not exactly riding a roller coaster, standing up with your arms in the air, but not far off.