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OK, perhaps you were right after all!

Benchmark bond yields rose moderately in the USA, UK and Germany during February, as stronger than expected economic or inflation data forced many investors to reassess their interest rate views and bring them rather more into line with the considered views of central bank governors.

Financial markets continue to focus on the strength of the US economy. Although monetary policy has tightened considerably in the past two years, its impact has been offset by a large budget deficit, solid household incomes and buoyant corporate profits. Hence, GDP growth still appears to be on course for 2-3% a year, only moderately slower than last autumn. Thoughts of a possible recession have been dampened by the continued strength of ISM business surveys or stabilisation in Conference Board leading indicator series. In particular, last month investors paid close attention to much stronger than expected employment numbers, which slashed the odds of a March interest rate cut, whilst the CPI reports continue to demonstrate underlying inflation pressures.

All this helps explain the tone and tenor of statements from central bank governors. Fed Chair Jerome Powell concluded that “Inflation is still too high. Ongoing progress in bringing it down is not assured”. Lisa Cook similarly said that “I would like to have greater confidence that inflation is converging to 2% before beginning to cut the policy rate”, whilst Governor Waller saw “no rush” to cut rates. The gap between what the financial markets are pricing in – four rate cuts – and what the Fed is signalling – three might be appropriate – is much narrower than last autumn.

Optimists might argue that circumstances are different this side of the Atlantic. After all, provisional data indicated that the UK economy was in a modest recession at the end of 2023. The decline in gas prices after a mild winter, and sizeable discounts across the high street in reaction to weak consumer spending, also mean that headline inflation should fall to or even below 2% by the late spring. However, the Bank of England continues to emphasise that it will pay more attention to labour market reports and core inflation data than GDP or headline CPI figures. Business surveys from CIPS suggest that the weakness in manufacturing was more than offset by further strength in the allimportant services sector, where activity is expanding at the fastest rate since May 2023. A positive demand for employees amidst tight labour markets means many companies are being forced to play catch up on wages.

The state of the labour market is difficult to understand at present, partly because of faults with the ONS surveys but also because of complex structural changes. Despite a stagnant economy, the UK is still suffering massive worker shortages (there are almost a million vacancies) yet this is happening against the backdrop of over 2.8 million people categorised as long-term sick. This may help explain the sense of division being seen within the Monetary Policy Committee. In February, the MPC voted 6-3 again to maintain the bank rate, but two members voted to hike rates and one member voted to cut it. The consensus view was expressed by the likes of Deputy Governor Dave Ramsden who worries that “Services inflation remains at levels well above what is consistent with the 2% inflation target. I’m looking for more evidence about how entrenched this persistence will be and therefore about how long the current level of Bank Rate will need to be maintained”.

Economic growth is even weaker in the EU than the UK; after a modest recession at the end of last year in the likes of Germany, the latest European Commission forecast is for GDP growth of only 0.8% in 2024. Credit growth in the euro area remains at a standstill, helping explain why measures of Euro area economic confidence continue to look gloomy. Yet Bundesbank President Joachim Nagel expressed a commonly held ECB view when he argued that as inflation remains stubbornly high so the ECB should resist the temptation to cut interest rates early, especially before crucial wage data in Q2. “Even though it may be very tempting, it is too early to cut interest rates. We will only receive a more detailed picture of how domestic price pressures are unfolding during the second quarter. Then we can contemplate a cut in interest rates”.

Labour market economists have much to consider at present. All central banks are clearly watching wages like a hawk. It is difficult to explain the puzzling strength of labour markets. On top of health problems, there is evidence of a hoarding impulse amongst many companies, compounded by severe shortages of skilled workers in areas including science, technology and construction. Usually when companies start to lay off staff, it is because their profits are getting squeezed and they need to cut costs to restore profitability – but corporate profits are in a reasonable state at present. Much more evidence of slack appearing in an economy is required before markets can start to price in more optimistic rate cut views.

Bond yields at the time of writing

10 year          %         Monthly move

USA                           4.30                            +0.25%

UK                              4.26                            +0.35%

Germany                   2.50                            +0.23%

Andrew Milligan is an independent economist and investment consultant. This note is offered as general commentary on economic and financial matters and should not be considered as financial advice in any form.



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