Global shocks and local surprises
On many occasions, financial markets are highly correlated, responding to common shocks or drivers. A classic example would be the shift out of equities into bonds in the face of the news that President Putin actually meant what he said about an invasion of Ukraine. At other times, financial markets begin to diverge, especially when local news dominates the international environment. This week was a classic example, when US investors interpreted inflation and political outcomes as highly supportive of lower bond yields, whilst European and UK markets largely stood to one side.
Expectations matter for markets. There had been forecasts that the US CPI report for October would, at last, be a reasonable one. The outcome was better than expected as headline inflation eased from 8.2% to 7.7% in the year to October, helped by clear signs that goods sector inflation is rolling over. There had also been expectations that the Republican party would do rather well in the mid-term elections. In the event, the red tsunami appears to be rather more of a red ripple. Although counting continues in several states, the likely outcome is gridlock in Congress between Democrats and Republicans. This is currently interpreted as making any major easing in fiscal policy rather less likely in the remaining two years of Biden’s term in office. The net result was that investors decided that the Federal Reserve was less likely to be aggressive, say a move of 0.5% rather than 0.75% in December, and the benchmark US bond fell sharply back below 4%.
Markets can get ahead of themselves. It is worth pointing out that service sector and housing inflation remains on an upward trend. The core CPI eased but at 6.3% year on year is still a long way above the Fed’s target. The employment report for October had shown the labour market was still quite strong with almost 2 job vacancies for every unemployed American. Lastly, inflation expectations remain well above the Fed’s objective. Against such a backdrop, it was not surprising that Richmond Fed president Tom Barkin told CNBC it was “conceivable” that interest rates could top out above 5%. Minneapolis Fed President Neel Kashkari said its “entirely premature” to discuss any pivot away from the Fed’s current tightening, as “I think we are on a good path right now.
Turning to Europe, economic data suggests that the region is headed for stagflation in coming months. Nevertheless, ECB Governors generally warn that there is more work to do before they can be sure that policy is restrictive enough. Admittedly Mario Centeno said expectations point to “inflation reaching a peak in the fourth quarter” and “we are certainly much closer to the neutral rate”. However, this contrasts with President Christine Lagarde saying there’s “still a way to go” on raising rates whilst “inflation everywhere is way too high”. There were warning remarks too from Bundesbank President Joachim Nagel: “I will do my utmost to ensure that we do not let up too early and that we continue to push ahead with monetary policy normalisation, even if our measures dampen economic development”. Such statements did not allow German bund yields to react too positively to the US news.
UK gilt yields did not move much on the week, as the latest economic data merely reinforced the prevalent view that the economy will be weak in the second half of the year. GDP was reported as down 0.2% in the third quarter, partly due to a slide in manufacturing output but also the effect of the Queen’s funeral on spending patterns. Into October, British Retail Consortium retail sales data showed a further slowdown in consumer expenditure on goods, while KPMG’s recruitment survey suggested weaker job hiring. However, MPC member Huw Pill reiterated that interest rates must go higher still to ensure inflation is brought back to its 2% target. He did acknowledge that peak interest rate of 5.25% priced in by the market is too high, but clearly markets are unsure whether the Bank’s views on future inflation are correct, especially against the backdrop of the recent decline in the value of sterling which should boost imported inflation.
Local news will dominate gilt markets in November. Next week sees the all-important Autumn Statement. The markets will have much to digest: the OBR’s latest forecasts on growth, inflation and public sector borrowing, and the Government’s announcements about the balance of tax and spending programmes over the next few years. After the shock and awe of the Truss/Kwarteng statement, many will hope for a rather more boring event on November 17th, albeit it must be likely that there are some surprises to affect market sentiment.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.33 3.95 3.82
UK 3.07 3.30 3.29
Germany 1.97 1.94 2.01
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