The elastic snapped back!
Bond markets have shown considerable volatility in recent days. When the market prices in one story, and unexpected news comes along, the reaction can be significant. Although the key driver was economic data in the United States, the effect rippled through to other major markets. The round trip in bond yields is worth emphasizing. As expectations grew that inflationary pressures were easing, the benchmark US 10 year Treasury yield fell as low as 3.35%, before snapping back to above 3.65% at the time of writing. The US 2-year bond has rebounded to 4.5%, its highest level since November.
All central banks have been emphasizing for months that the direction of the labour market remains extremely important for decision making. The latest American report was therefore awaited with great interest. Jobs data shocked investors; hiring surged in January, as payrolls increased by 517,000, more than double the level anticipated by economists. The unemployment rate reached a 53 year low of 3.4%, well below the 5% level which Federal Reserve models suggest is required to push wages growth down to sustainable levels. Over the year to January, hourly earnings were up 4.4%. Prior to the pandemic they were running about 2.0-2.5% a year. The effect was amplified by an important survey of the services sector which showed renewed strength in January. The combination of these reports altered expectations for future interest rates with the peak in US rates back at 5.25%.
Fed officials did not stand in the way of such a reassessment. Fed Chair Jerome Powell commented “It kind of shows you why we think this will be a process that takes a significant period of time”, the “disinflationary process” still had a “long way to go” and “it’s probably going to be bumpy”, indeed “it may well be the case” that the Fed would have to raise rates “more than is priced in” by financial markets. He is concerned that the pandemic has had a lasting legacy on the jobs market which will be structurally tighter for longer due to the absence of potential workers. His colleagues on the Federal Reserve made similar remarks. John Williams said moving to 5% to 5.25% “seems a very reasonable view of what we’ll need to do this year in order to get the supply and demand imbalances down”. Indeed Neel Kashkari said he believed rates would have to go to 5.4%.
Interlinked bond markets mean developments in the USA affect the global cost of money. UK gilt yields also moved higher, if not as much or as fast. This occurred despite weak economic data and dovish comments from Bank of England officials. The UK economy appears to be flatlining at present, according to the latest GDP reports. British Retail Consortium sales data for January showed falling real retail spending. Looking ahead, the NIESR estimates that the UK will grow modestly by 0.2% this year rather than falling into a recession. The Bank is signalling that it will soon stop and assess the situation. Chief Economist Huw Pill said they must avoid going too far on lifting rates, while Andrew Bailey emphasized that headline inflation should fall back sharply during the course of this year, to end the year below 5%. Concerned as they are about “persistent inflation” such policymakers will pay particular attention to developments in the service sector. They will also want to see improvements in wage and price-setting behaviour in the Bank’s surveys of businesses. All in all, markets are pricing in one, at most two, more 0.25% moves in March and April.
US data rippled through to the European market as well. On and off the record conversations with half a dozen ECB policymakers suggested a common view, that rates will rise again by at least 0.25%, probably 0.5%, in May. Dutch central bank governor Klaas Knot said the ECB may extend its streak of large interest rate hikes into May if core inflation doesn’t ease by then. The next set of European inflation figures will be analysed with interest , but certainly Germany’s latest report showed little improvement. As Joachim Nagel warned “Decisive monetary policy action is necessary to reduce the risk of an un-anchoring of long term inflation expectations”.
At the end of last year, the consensus view was that 2023 would be a year of moderate recessions or at most slow growth. The rapid decline in energy costs and the speed of the improvement in the Chinese economy is altering such a view. Indeed, the global economy appears to be stabilizing or even improving a little at the start of the year. January’s global business survey in the PMI series reported output had picked up for the second consecutive month to reach the highest level since July 2022. This opens the risk that inflation could become sticky later in the year, further worrying central bankers and encouraging another reassessment of whether the peak in rates has been seen or whether they might decline as quickly as some expect.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.50 3.88 3.68
UK 3.60 3.34 3.41
Germany 2.74 2.39 2.37
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