A post in November suggested that emerging equity markets were losing their lustre, with anti-inflation policies likely to slow growth in 2011 and valuations looking ambitious relative to developed markets.

Prices are bouncing today but, as of Friday's close, emerging markets had lost 5.1% year-to-date in US dollar terms versus a 5.0% gain for developed markets (MSCI return indices). The recent setback has wiped out outperformance since September 2009 – see first chart.

Three of the four BRIC markets look in trouble. Chinese and Indian three-month market rates have risen by 200 basis points (bp) since November. A sharp deterioration in China's trade balance in January partly reflected holiday distortions but a surge in imports is consistent with overheating – second chart. Indian banks' three-month funding costs are now more than 100 bp higher than the 10-year government bond yield, implying restrictive policy. In Brazil, real narrow money, M1, has contracted over the last six months. Russian monetary conditions are loose currently but inflation is picking up strongly.

Six-month growth in E7 industrial output strengthened in late 2010, as did a composite leading index derived from the OECD's country indices. A "double-lead" indicator based on the short-term momentum of the leading index, however, weakened in November and December, signalling a peak and slowdown in output momentum this spring – third chart. With a likely further rise in inflation precluding policy loosening, markets may fret about an economic "hard landing" later in 2011 and 2012.

The US Treasury's decision to reduce its "supplementary financing program" (SFP), under which it issues additional bills and places the proceeds on deposit at the Federal Reserve, will result in a large increase in bank reserves and the monetary base over coming weeks, on top of the impact of the Fed's continuing securities purchases.

The SFP is being run down to delay the national debt hitting the current authorised ceiling of $14.29 trillion, which Congressional Republicans are resisting increasing. Even with this initiative, debt is expected to reach the limit by mid-May at the latest. The Treasury has announced that the SFP will decline from $200 billion to $5 billion. A reduction to $175 billion occurred over the last week.

The $195 billion planned decline will feed directly into bank reserves and the monetary base (i.e. reserves plus currency in circulation) as the Treasury repays bills by running down the balance in its Fed account.

As previously noted, the Fed is on track with its plan to buy a net $600 billion of securities by mid-2011 but the increase in bank reserves has so far fallen short of purchases – see chart. This seems to reflect exogenous factors (such as a repayment of Fed credit by AIG) though could hint that officials are becoming concerned about overstimulating the economy.

The SFP run-down, however, is likely to push bank reserves and the monetary base above the QE2-implied path. Assuming that the SFP falls to $5 billion as planned, and continuing Fed securities purchases are unsterilised, reserves may reach about $1.46 trillion by the start of April – $470 billion or 48% more than when QE2 was announced in early November. Completion of the QE2 programme would imply a rise to about $1.68 trillion by mid-year – equivalent to 11% of annual GDP.

A further liquidity injection could sustain increases in commodity prices, fuelling bond market inflation worries. With the US economy apparently performing strongly in early 2011, the Fed may soon come under pressure to scale back QE2 or sterilise the impact, for example by auctioning term deposits.

The mark-to-market profit on the Bank of England’s gilt purchase programme has fallen from an estimated £26 billion in August to £10 billion as gilt yields have risen to a nine-month high – see chart. A further 50 basis point increase in yields would be sufficient to push the scheme into a loss.

Very roughly, a 10 basis point change in yields affects the P&L by £2 billion.

The Bank bought £198 billion of gilts between March 2009 and January 2010, initially of between five and 25 years' maturity although the range was later widened. The calculations are based on a 15-year gilt. Weighted by the Bank's monthly purchases, the average 15-year redemption yield was 4.16% over March 2009-January 2010, slightly below the current 4.25%, suggesting a capital loss of about £3 billion.

Capital erosion, however, has been more than offset by net interest income of an estimated £13 billion as the Bank has “played the curve” by creating reserve money on which it has paid Bank rate of 0.5% to finance its higher-yielding gilt portfolio.

The P&L of the purchase programme is not currently included in the fiscal deficit measure targeted by the government – public sector net borrowing excluding temporary effects of financial interventions – but will be when the scheme closes, presumably after the gilts are sold back to the market.

The Bank was right to initiate asset purchases to alleviate a liquidity squeeze in early 2009 although the subsequent expansion of the programme was questionable. It would be unfair to judge the success of the scheme simply on the basis of its final P&L but a large loss would be embarrassing for officials already under attack for their handling of the financial crisis and failure to predict the current inflation overshoot.

Last week's solid purchasing managers' surveys for January supported the scepticism expressed in a previous post about the official assessment that underlying GDP performance (i.e. after adjusting for the impact of bad weather in December) was "flattish" in the fourth quarter.

Further evidence that the economy is still expanding is provided by the Monster employment index, which tallies vacancies posted on job boards (not just monster.co.uk) and corporate career sites. After adjusting for seasonal variation, the index rose sharply in January, reaching its highest level since November 2008. This confirms the message of the Reed job index released last week. (The Reed index covers only opportunities posted on reed.co.uk and has a shorter history than the Monster survey.)

The Monster index tracks or leads the official vacancies series – see chart. Vacancies are a coincident indicator of GDP and lead employment. The January increase, therefore, suggests that GDP is growing solidly in early 2011 while employee numbers will rise over coming months, reversing a small decline in late 2010.

Consensus pessimism about labour market prospects partly reflects worries about public-sector job losses but these are scheduled to be staggered over several years. Of a 330,000 fall in general government employment between 2010-11 and 2014-15, the Office for Budget Responsibility projects only 40,000 to occur by March 2012.



US capital goods manufacturers are increasingly bullish about their domestic sales prospects, according to a report in today's Financial Times. This accords with the ISM's December semi-annual investment intentions survey, indicating that manufacturing firms planned a 15% increase in capital spending in 2011, the largest since 1998 – see first chart.

Labour demand typically follows investment. January's jobs gain was depressed by bad weather but business surveys suggest that private payrolls expansion should strengthen significantly – second chart. Online job advertisements surged in January, as noted in a post last week.

A return of corporate "animal spirits" is also evidenced by a recent revival in bank credit demand. Commercial and industrial loans are still down by 5% from a year ago but have risen since the autumn, with the Federal Reserve's latest senior lending officer survey pointing to a further pick-up – third chart.

Rising corporate credit needs are clashing with a widening federal deficit, contributing to upward pressure on bond yields, despite the Fed's QE2 programme. (The Congressional Budget Office projects a rise in the deficit to 9.8% of GDP in fiscal 2011 from 8.9% last year.) A resumption of C&I loan growth in 1994 coincided with a severe Treasury bear market – the final chart draws an ominous comparison with recent yield movements.

Yesterday's post suggested that UK rates will rise soon. It would be unusual for the MPC to tighten policy when the Federal Reserve is still loosening, via its QE2 securities purchases. Will the Fed's stance also shift over coming months?

The first chart shows US official interest rates together with a leading indicator of Fed policy based on trends in unemployment and core inflation and a measure of supply bottlenecks from the ISM manufacturing survey. The indicator is constructed so that a positive reading signals a need for tighter policy and vice versa. (The Fed has stated a target for the Fed funds rate since 1995; the discount rate is used as the official measure for earlier years.)

The indicator turned negative in June 2007, three months before the first Fed rate cut and six months before the onset of the recession. It continued to weaken during 2008 and early 2009, reaching a trough in May before embarking on a sustained recovery. Since mid 2010 the indicator has been hovering just below zero.

Of the components, the ISM bottlenecks measure is already positive. Labour market leading indicators, meanwhile, suggest that the unemployment component will move above zero during the first half of 2011. Core inflation, therefore, may need to fall further to keep the indicator in negative territory. Core CPI trends, however, may deteriorate, with goods inflation boosted by pass-through of cost increases and the important housing rents component firming in response to a falling rental vacancy rate.

So the Fed leading indicator could turn positive as early as this spring, suggesting an increase in official rates in the late summer.

The second chart shows how the Fed is progressing with its plan, announced in November, to buy a net $600 billion of securities by mid-2011. While the purchase programme is on track, the impact on bank reserves and the monetary base has been smaller than expected, implying partial sterilisation. This could indicate that the Fed is already concerned about overstimulating the economy; there is an outside chance that it will end QE2 early in the event of strong data over the next couple of months.