10-year Treasury yields have risen by 106 basis points (bp) from a low on 6 October and by 99 bp since a post on 5 November, drawing attention to a warning signal from the Korean bond market.

Yields could consolidate or correct lower following the recent surge; the Korean market has moved sideways since early November. Longer-term investors, however, should note that current levels continue to represent very poor value by historical standards.

The first chart shows 10-year yields, on a quarterly average basis, together with consensus 10-year consumer price inflation forecasts compiled by the Philadelphia Federal Reserve (i.e. from the Philadelphia Fed's Survey of Professional Forecasters since 1991 and from either the Livingston Survey or Blue Chip Economic Indicators for earlier years). Consensus numbers are unavailable before 1979 but can be proxied by an exponentially-weighted moving average of actual inflation.

The second chart shows an estimate of real yields calculated by subtracting the consensus 10-year inflation forecasts (or proxy numbers before 1979) from the quarterly-average nominal yields.

In the first quarter of 2009 and the third quarter of 2010 real yields stood at just 0.3% and 0.5% respectively, well below previous post-war lows of 1.2% in the late 1950s and mid 1970s and 1.1% in 2003.

At the current level of about 3.5%, nominal yields are still only 1.3 percentage points above the consensus 10-year inflation forecast of 2.2%, as reported in the fourth-quarter Survey of Professional Forecasters. To return real yields to their median level of 2.7% since the early 1950s, nominal yields would have to rise to 4.9%, assuming no change in consensus inflation views. 

CPI inflation rose to an annual 3.3% in November and remains on course to reach 4% in early 2011, reflecting the impact of soaring commodity prices, the VAT hike and a stubborn “core” trend, which continues to defy Bank of England predictions of a slowdown in response to economic slack and fading exchange rate effects.

The November rise was driven by a pick-up in goods inflation from 2.6% to 2.9% as the food, alcohol and tobacco component moved up from 5.0% to 5.8% and non-energy industrial goods inflation firmed from 1.1% to 1.4%, mainly as a result of price hikes for clothing and household goods. Food inflation remains likely to reach 7% soon, as suggested in a post in September. Energy inflation fell from 4.0% to 3.5% but is heading significantly higher as recent rises in gas and electricity tariffs take effect. A further increase in overall goods inflation is also suggested by CBI industrial price expectations – see first chart.

Services inflation moderated from 3.8% to 3.7%, mainly reflecting a slowdown in transport services, but the VAT hike is likely to push it above 4% in the new year.

“Core” CPI inflation – excluding energy, food, alcohol and tobacco – was stable at 2.7% in November.

Key influences on the headline CPI rate over the next few months will be:

• Higher VAT pass-through than a year ago – estimated upward impact of up to 0.6 percentage points (pp). The Bank’s regional agents’ survey reports that most firms plan to pass on the hike in full.

• Announced increases in home energy tariffs – about 0.4 pp by next spring.

• Higher food commodity costs – 0.2 pp assuming annual food inflation reaches 7%.

• Higher vehicle fuel costs, with unleaded likely to rise above £1.25 per litre – little impact because of a similar increase a year ago but previously-expected downward effect no longer operative.

• Secondary food price effects via the “catering services” CPI component – 0.1 pp assuming annual inflation rises to about 4% from 3.3% currently (up from 3.0% in June).

• Accelerating housing rents – 0.1 pp assuming a rise in annual inflation from 1.5% in November to about 3%. Private-sector rents are growing strongly, according to the RICS letting agents' survey – second chart.

High inflation threatens to slow the economic recovery by squeezing real incomes and money balances. By refusing to raise interest rates because of coming fiscal tightening, the Bank is encouraging high pass-through of cost-push pressures and a rise in inflationary expectations, thereby entrenching the current overshoot. Far from supporting the economy, its actions risk damaging medium-term growth prospects.

US employment figures for November were disappointing, showing a rise of only 50,000 in private-sector payrolls. Private job openings (i.e. vacancies), however, increased sharply in October, reaching a 26-month high, suggesting that employment growth will pick up in early 2011 – see first chart. (Openings are released a month later than payrolls but lead turning points in the latter by about six months.)

Job openings are rising at a similar pace to 2005, when private payrolls increased by nearly 200,000 a month. Assuming no change in government jobs, such growth would result in a steady decline in unemployment – payrolls need to rise by about 110,000 a month to keep the jobless rate stable, based on the recent rate of expansion of the working-age population and a constant labour-force participation rate.

In further evidence of improving US economic momentum, the six-month rate of change of the OECD's US leading index stabilised in October while a "leading indicator of the leading index" strengthened for the third consecutive month – second chart. This improvement is occurring on schedule following an acceleration in US real narrow money since the summer, highlighted in numerous previous posts.

The view here remains that the Federal Reserve's QE2 liquidity boost was unnecessary and is likely to prove counterproductive.