QnD: UK Disinflation (not priced)
The UK Inflation data was released today, which unsurprisingly showed more disinflationary pressure in both the headline and core rates. What is surprising, however, is the continued optimism about the prospects for future inflation that is priced into financial markets.
THE DATA: Below is a summary of the headline and core data, broken down into the basket's components (CPI top, RPI bottom):
Note that despite the decline in Headline and Core Rates, REAL average earnings has declined (unsurprising given the rise in the unemployment rate and decline in GDP).
INFLATION BREAKDOWN:
Given the large year on year percentage decline in oil, there is still a downward pressure on the headline inflation rate from components impacted by energy prices. This will not "mean revert" until the end of the year (unless there is a substantial rise in oil prices).
Despite the rise in food prices, Burden inflation has declined to negative due to the energy deflation impacting utilities and transport costs. Choice inflation remains very low.
This is the same chart, but for RPI (important for wages that are linked to RPI). Despite the decline in Burden inflation, Real Wage growth, deflated for Burden inflation, has declined to almost zero, which is not great for future consumption of a highly levered household sector.
HOUSING
Like the US CPI data, Housing has a large weight in the UK RPI basket. Housing (ex MIPS) deflation took the Core RPI negative after the GFC (left). Today's data saw further disinflation in the housing component (right), dragging the UK Core RPI to its lowest level since Dec 2009.
MARKET PRICING
The data shows strong disinflationary forces, which are to be expected given the extraordinary decline in GDP led by a drop in consumption and rise in unemployment. However the market remains very optimistic that these disinflationary forces will be very short term in nature, which is very different to expectations in the US and Eurozone.
The following charts show the current Headline (Blue) and Core (Red) rates of inflation in the Eurozone, US and UK, as well as the spot (Green) inflation curves and the one year forward (black) inflation curves. This last (forward) curve depicts the market's expectation of the annual inflation rate in the future.
In both the US and Eurozone, the market expects inflation to be below or at current core rates for the next 1 and 5 years respectively, and to remain low for a long protracted period. In the UK there is no such expectation - the black line shows how inflation is expected to rebound quickly.
This positiveness can also be seen by comparing today's expectations with those in the past. Charts below, again for the Eurozone, US and UK, show current forward inflation rates (black) with three other curves in the past (purple, blue and green represent previous times of low inflation). The EUR and US markets price in that inflation this time will remain low for longer compared to previous times, whilst this is not the case at all for the UK.
CONCLUSION
The UK inflationary data reflects the disinflationary forces in the weak economy, which are unlikely to change soon. Companies are being supported by generous fiscal policy aid, meaning that there is unlikely to be a supply shock for the time being. Worryingly, despite the decline in inflation, real wages are also declining which makes a rise in consumption tough (assuming there is not a significant rise in borrowing). There is also the question of what happens to the housing component.
The market is taking a completely different tack, pricing in a swift return to higher inflation, which offers a very good opportunity. Unlike equity markets, Central Banks cannot influence the inflation market over time - its purely a mathematical trade based on the index.
If those forward inflation rates decline, that will have a quite extraordinary impact on Gilts, whose yields are only positive due to these high inflation breakeven rates.