Munix Weekly 10th June 2022
“Central bankers will not be lying on the beach”
As June creeps towards July and August, many investors are turning their thoughts towards a holiday, perhaps at home, perhaps braving the perils of international air travel. Central bankers are hard at work, however, planning a series of interest rate moves in coming months, alongside sharp declines in their purchases of government bonds. Such thinking has resulted in a steady but noticeable rise in short and long dated bond yields; indeed for gilts and German bunds the benchmark 10 year yields are now the highest since early 2014.
One reason driving yields higher has been the latest series of inflation forecasts from international organisations such as the OECD. It expects the CPI rate in the UK, for example, to average 6-7% in both 2022 and 2023. Even though headline inflation in the USA and Germany is on a slightly lower path, they are still expected to be 3-4% next year, well above central bank targets. This is despite a widely expected pronounced slowdown in economic activity, demonstrating how entrenched inflationary pressures currently are. Rapidly rising costs, such as £100 to fill an average car with petrol in the UK, are rippling through the system, whilst supply chain problems remain intense in many sectors.
Such costs pressure does squeeze household incomes and company profits of course. Hence, the World Bank slashed its forecast of global GDP growth this year to only 2.9%. It warned that the risk of stagflation was considerable, and that the world should prepare for “several years of above-average inflation and below-average growth”. Again the UK stands out with economic growth expected to be flat in 2023 according to the OECD, versus rates of about 1-2% a year for Europe and the USA. Central bankers will be concerned that such historically weak growth means that another major shock could easily result in recessions appearing.
Against that backdrop, the sharpest moves in bond markets have been across Europe. This reflects the more hawkish tone and tenor of recent ECB statements. Whilst it did not act at its June meeting, it firmly signalled that rates will move up by 0.25% in July and in September, the first increases in a decade, whilst leaving the door open for a 0.5% increase if inflation does not improve sufficiently. It will also begin to reduce its balance sheet holdings of government bonds from the start of July; subsequent tensions across Italian and other peripheral European bond yields have led some bearish commentators to draw parallels with the Eurozone sovereign debt crisis of the early 2010s. Updated ECB forecasts help explain its desire to act – while it expects economic growth as low as 2.8% in 2022 and 2.1% in 2023, headline inflation at 6.8% and 3.5% in those years would not be in line with its mandate. ECB economists will also be well aware that the accuracy of their inflation forecasting has collapsed since spring 2021.
The scale of the turnaround in thinking about European rates is notable. Less than three months ago, the official rate was still widely expected to be negative by the end of the year; now it is possibly 0.75% or higher. The market expects the ECB to have to take rates close to 2% before this phase of tightening is over.
US 10 year yields have again moved back above 3%. The Fed’s course of action was pretty clear, even before headline inflation for May came in a little worse than expectations – up 8.6% from a year earlier, the highest rate since 1981. CPI excluding food and energy running at 6% a year shows how a wide array of factors are driving inflation higher, not just gasoline costs reaching an eye watering $5 per gallon. Vice Chair Lael Brainard said in a speech “market pricing for 0.5% moves potentially in June and July, from the data we have in hand today, seems like a reasonable path”. The market is expecting the Fed to get to roughly 3.25% by June of 2023 before having to pause or cut rates. The latest US 10 year bond auction saw tepid demand, suggesting continued uncertainty about the inflation outlook. This chimes with the latest Bloomberg survey indicating only a moderate deceleration even when inflation is proven to have peaked.
International capital flows and the global nature of the inflationary shock mean that no one market can stand alone. The Bank of England has been in purdah in the run up to its meeting next week. Subsequent comments by the Governor will be examined with great interest. There is the possibility of some volatility in sterling money markets, as investors currently price in a further 1.75% of MPC tightening by year-end – yet another country where investors struggle to buy into the idea of a pause soon.
All these interest rate decisions and warnings by the ECB, MPC and Fed should be put into context. Other central banks, such as Australia, and Chile, and India, and Israel, and New Zealand, and Poland, and South Korea, have all moved in recent days. Inflation is a global phenomenon and requires urgent action, so a busy summer lies ahead for many central bankers around the world.
Bond yields at the time of writing this week and one month change
% 2 year 5 year 10 year
USA 2.84 (+0.23) 3.08 (+0.18) 3.06 (+0.07)
UK 1.86 (+0.54) 1.96 (+0.47) 2.33 (+0.47)
Germany 0.83 (+0.67) 1.20 (+0.50) 1.44 (+0.43)
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