Three steps forward, two steps back
December and January were very different months for the bond markets. The former saw noticeable declines in bond yields, as more investors bought into the soft landing story for the coming year. However, during January expectations for rate cuts were dampened in all the major economies, partly as economic growth has been more robust than many expected, and partly as central bankers continue to insist that they need to see further improvements across the inflation pipeline. The end result was benchmark US, UK and German bond yields ended January about 0.15-0.25% higher than at the start of the month.
In many respects, the key drivers for bond markets have not changed since the start of the year: growth and inflation expectations, signals from central bankers, geopolitical concerns. However, as each statistic was released the effect on asset prices depended on how much good news had already been priced in.
In the USA, the data suggests that while inflation is on course to reach the Federal Reserve target, economic growth remains rather healthier than many had expected. Whilst headline CPI inflation remains above 3% year on year, the Fed’s preferred consumer spending inflation measure is on target to reach 2% – differences reflect the emphasis on such areas as housing and medical costs. Economic growth has rather surprised to the upside though – GDP was growing about 3% from a year ago in both Q3 and Q4 whilst retail sales, industrial production and ISM data suggest at least 2% a year into Q1. The lagged effects of monetary tightening are slowly working their way through labour markets, but supply/demand factors still enable wages growth of 5-6%.
At the start of the year, rather optimistic rate cut expectations were priced into the markets, with the first move as soon as March. Fed officials have pushed back, and successfully dampened expectations, although the forthcoming Fed meeting will be analysed with interest. Hawks worry about the very sizeable mountain of new government debt, approaching $8 trillion, which the market will need to absorb in the coming year. The dark cloud of the US Presidential Election also looms on the horizon, although the implications for fiscal policy are rather uncertain.
Christine Lagarde and other members of the ECB have similarly taken great pains to point out to the market that the summer rather than the spring remains the more likely timescale for rate cuts. Yet, it is easy to see why the market is excited about the possibility of a move in Q2. The economic performance of the Eurozone was distinctly weak towards the end of last year – GDP was broadly flat in Q4 – with consumer spending and overseas trade both misfiring. A moderate recession is being experienced in some countries such as Germany, and PMI surveys only showed signs of business activity at best bottoming out rather than showing any acceleration. Monetary conditions are restrictive; banks continue to tighten their credit standards to enterprises and business demand for loans weakened once more. However, the transmission into labour markets is still far too slow, with wages growing over 5% from a year ago.
The weak European backdrop provides plenty of ammunition for doves on the Bank of England’s Monetary Policy Committee to argue that financial conditions have become too restrictive. Nevertheless, they also face several problems. The first is the labour market remains tight, keeping wages growth well above 6% year on year – albeit the ONS admits that its data sources are not fully accurate at present. In addition the latest CIPS business surveys suggest that activity may pick up moderately into the spring. The second issue is the Budget approaching in March – will the Chancellor follow through with his promises to cut taxes significantly by around £10 billion, as public sector borrowing has been less than forecast? It may be a blatant election ploy, but the Bank will want to assess the situation in the spring and its potential impact on the economy before making any decisive changes to rates.
Overhanging all such domestic economic policy analysis, there are several geopolitical issues which should not be ignored. Front and centre is the deteriorating position in the Middle East, and what this might mean for freight costs and the price of oil. After several years when central banks have finally got on top of the energy price shock sparked by the Ukraine-Russia war, it would be deeply unfortunate if any one of a number of geopolitical or climate or financial risks upended their thinking. Until then, markets have priced in a series of rate cuts across all the major economies in 2024 but for such a result to appear, consumer inflation and wages need to fall quickly towards target whilst economic growth needs to slacken even further. Otherwise February may follow the story of December and January – three steps forward, two steps back.
Bond yields at the time of writing
10 year % Monthly move
USA 4.08 +0.13%
UK 3.90 +0.26%
Germany 2.27 +0.25%
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.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making