The substantial increase in the US government deficit in the past 4 years (and the associated support from the Fed) suggests structural upward pressure on US inflation in the coming years.

In addition, if we look at the University of Michigan’s inflation expectations (above)one year forward, there is not anything to suggest that the current low level of inflation should not revert to average.

Finally, it is worth emphasizing the small, but noticeable, pickup in private average hourly earnings.

Earnings appear to have bottomed in mid 2012 (at about 1.4% YoY) and are now growing at 1.7% YoY.  History indicates a tight correlation between the Fed Funds rate and private labour earnings growth, but to suggest that private earnings currently form an important part of the Fed’s reaction function is a stretch. However, it is worth paying attention to this indicator, especially if it continues to rise, as this would put pressure on rates to rise.

You can play the clip here through BBC’s iPlayer (UK viewers only, sadly!)

May 30 (Bloomberg) — Jonathan Tepper, chief executive officer at research firm Variant Perception, talks about asset bubbles, the Spanish economy and monetary policy. He speaks with Mark Barton and Anna Edwards on Bloomberg Television’s “Countdown.” (Source: Bloomberg)

Banks are the single largest holder of JGBs in Japan.  Interest rate sensitivity has remained the same for the major banks, but has increased for Regional and Shinkin banks (bottom chart).  A 100bp parallel rise in rates would create losses of about 10% of tier 1 capital for the major banks.  However, the figure for the regional and shinkin banks is much higher, at 30-40%.

This is due to QE, which has lowered yields, increasing portfolio sensitivity to yield in its own right, and has caused mainly the non-major banks to increase their bond-portfolio duration to try to eke out a higher return (in a “reach for yield”).  It is the Regional and Shinkin banks, rather than the majors, that tend to perfunctorily sell positions when volatility rises.  This can be self-reinforcing.

One of the channels through which conventional QE works is using the commercial banks’ balance sheets as a positive lever, with central bank reserves serving to encourage the creation of loans.  Japan risks anti-QE, where the banks are forced to push the lever the other way, contracting their loan books as falling JGBs destroy their capital ratios (please click on graphics for larger view).

Source: BoJ

Company borrowing has surged, and corporate bonds outstanding in the US now outnumber mortgage-backed securities. At the end of 2012, there was $8.6 trillion worth of corporate debt outstanding which compares to $8.2 trillion in mortgage-backed securities (please click image for larger view).

It is only reasonable to expect the next crisis to hit will materialise in the (global) corporate bond market and that future QE programs and liquidity provisions will involve corporate bonds. The yield on corporate bonds in many cases is so low that investors are not even being  compensated for the probability of default based on historic default rates. Yield is now being sought in all corners of the world without consideration of underlying risks. As long as yields are higher than the benchmark (which is ZIRP), any yield is attractive. Using a metaphor originally coined by the Economist’s Buttonwood, yield-hungry investors are now picking up dimes in front of the proverbial steamroller. The merits of aggressive central bank monetary policies can be debated, but the effects are certain.

In the US, a new credit cycle has started outside mortgage creation, and the real question is how far this cycle will go and when it will end. Given the historical relationship between credit growth and volatility in the US, our indicators would suggest that we are on the verge of a new volatility cycle in the US.

If you would like to read this report in full, please click here.