The UK starts to fall behind
In recent weeks, financial markets have adjusted their views about the outlook for interest rates into 2023. On the one hand, the strength of the US economy and the pace of European inflation is encouraging many central bankers to talk in a hawkish manner. Conversely the Bank of England is proving rather more cautious in its approach, unless the forthcoming Budget springs some surprises.
The highlight of the week for many investors was testimony to Congress by Federal Reserve Chair Jerome Powell. He could not be clearer that the Fed is prepared to switch back to larger interest rate increases if the US economy continues to grow too quickly. ” The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated. If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes”. Other speakers joined him. “It’s clear there is more work to do,” Mary Daly warned, reiterating support for a peak rate of between 5.0%-5.5%. Thomas Barkin also favoured a more deliberate tightening pace, and said it will take “a lot more time and effort” to get inflation back to target. Against that backdrop, it was little surprise that the two-year Treasury note yield increased close to 5% for the first time since July 2007. This uptrend may be bolstered by the next round of Fed official forecasts (the so called dot plots) due on 22nd March.
The European Central Bank similarly continues to warn about the need for further action. A rate hike of 0.5% on 16th March looks like a done deal. ECB President Christine Lagarde said underlying inflation in the eurozone will stay high in the near term, so such a decision is increasingly certain as “inflation is a monster that we need to knock on the head”. The more heated debate may well be about the path for monetary policy beyond the next meeting . One hawkish representative was Robert Holzmann, who called for four successive 0.5 percentage point rises in eurozone interest rates. Philip Lane tried to calm things down by suggesting the ECB should not go onto autopilot but assess the data. However, the backdrop remains a tight labour market. Given that many European companies are reporting record profits, there is little sign of businesses laying off staff to any great extent. The Eurozone unemployment rate in January at 6.7%, roughly where it has been since April.
A more positive global economic backdrop into 2023 will also be supported by plans announced at the Chinese Congress for economic growth to return to 5% this year. Targets are always uncertain, but the government realises the need to create 12 million new jobs after the protests seen last year. The impact is rippling through to European activity. German industrial output rose 3.5% month on month in January, and order books improved too.
In contrast, UK economic data remains muted and central bankers cautious. The British Chambers of Commerce forecasts that, although the UK will avoid a recession this year, sluggish growth means the economy will not recover to pre-pandemic levels until the final quarter of 2024. MPC member Swati Dhingra said “In my view, a prudent strategy would hold policy steady amid growing signs external price pressures are easing, and be prepared to respond to developments in price evolution. This would avoid overtightening”. Her colleague Catherine Mann is assessing whether hawkish remarks from the ECB and the Fed may weigh heavily on the pound and prompt more rate rises in the UK.
The MPC will also take a cautious stance ahead of the Budget due on 15 March. The National Institute for Economic and Social Research proposes that “a combination of higher revenue and lower spending, together with the more favourable outlook for GDP and interest rates, means that the Chancellor has a large amount of fiscal space ahead of his budget. We estimate this to be £166 billion (5.1 per cent of GDP) for his deficit target and £97.5 billion (2.9 per cent of GDP) for his debt target.” How much of this will be aimed at such targets as energy packages or business investment or corporate taxation or reducing public sector debt might help determine whether the MPC continues to diverge from, or start to return towards, the more aggressive stance being seen in Europe and North America.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.96 4.25 3.93
UK 3.82 3.70 3.82
Germany 3.26 2.77 2.62
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