Growing Inflation Concerns in Asia

Another much better day for eurozone peripheral bonds, aided by Japan's words of encouragement and some further buying from the ECB. Following China's declaration of support recently, some of the worst-affected eurozone sovereigns suddenly looked less vulnerable. If Japan and China both participated in upcoming auctions (and they certainly possess the firepower in terms of fx reserves), and the ECB was a buyer as well, then perhaps these sovereign bonds were not so smelly after all. This at least seemed to be the thinking yesterday. The Greek 10yr yield fell 70bp yesterday to 11.59%, a decline of 100bp since the start of the week. Likewise, the Irish 10yr yield fell more than 30bp to 8.4% at one stage, and Portugal's 10yr was 10bp lower at 6.85%. The improved tone in eurozone peripheral bonds extended to the single currency, with the euro attracting some buying interest over the course of the day and again overnight. In the short term, some key hurdles remain, with Portugal holding bond auctions today and Spain tomorrow. Die Welt reported this morning that the size of the EFSF may be increased and the interest rate charged to Ireland for its bailout reduced, a story that might offer the euro some further support in early trading.

India's growing inflation concerns. In Asia's two largest economies, rising inflationary pressures represent the number one issue for policy-makers at the present time. In India, food prices jumped by more than 18% in the week before Christmas. Wholesale prices, due to be released on Friday, are expected to have risen by 8.4% YoY in December, up from 7.5% in the previous month.

On Tuesday, India's Prime Minister held a meeting with senior ministers and policy officials to discuss ways to control the explosive growth in food inflation. The Indian central bank lifted key interest rates on six separate occasions in 2010; its next meeting is scheduled for two weeks' time. India's Sensex has fallen more than 6% already this year over worries of rising inflation and the potential for higher interest rates.

China's booming capital inflow. Yesterday's latest figures on Chinese foreign exchange reserves offer some interesting perspectives on developments in the country's capital account. At the end of 2010, fx reserves stood at $2.85trln, up from $2.4trln at the end of the previous year. In the final two quarters of the year, fx reserves soared by just under $400bn. China recorded a trade surplus of around $130bn over the second half of last year. As such, capital inflow probably accounted for around two thirds of the increase in fx reserves over this period. Little wonder that China's policy officials are accelerating their efforts to internationalise the yuan and open up the capital account to try and encourage capital outflow by the private sector. Separately, the government is endeavouring to tighten liquidity domestically, although this is proving very challenging. There is a flood of central bank bills due to mature and a number of the major banks will likely front-end their new lending for the year. It is entirely plausible that the PBOC will need to tighten monetary policy further in coming months, both through raising bank reserve ratios and lifting benchmark interest rates.

UK's inflation dilemma. A further reminder for the MPC overnight of rising inflationary pressures, with the latest BRC shop price index rising 2.1% YoY in December. According to the BRC, food price inflation was running at 4% in December. More generally, retailers are under pressure to try and lift prices to protect profit margins in response to rising commodity prices, including oil, cotton, coffee and wheat. At the same time, retailers have been discounting heavily wherever possible after being lumbered with excess inventory as a result of December's adverse weather.

Plosser suggests QE2 needs to be reviewed. Philly Fed President Charles Plossser, regarded as one of the more hawkish members of the FOMC (he is a voter this year), indicated yesterday that he would favour a review of QE2 if the economy began to grow too quickly. Plosser was not in favour of QE2 when it was undertaken in November and, as such, can be expected to continue to evaluate the Fed's program of asset purchases critically. Another hawk on the FOMC this year is Richard Fisher, the Kansas City Fed President, who has also expressed reservations about QE2 in the past.

Aussie recovers despite dovish RBA rhetoric Overnight it was the Aussie that caught the eye, with some dovish rhetoric from the RBA regarding near-term monetary policy in the light of the Queensland floods sending the AUD down to a four-week low near 0.98. However, some strong buying interest emerged at the lows, and in early London trading it is back near 0.99, in what can be described as an impressive bounce.

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