Weekly update 12th April – by Andrew Milligan

MUNIX COMMENTARY – WEEK OF 12 April

Divergent views, same outcomes

Sometimes small numbers really matter. The difference between 1.78% and 1.63% is only 15 basis points, hardly the most earth-shattering shift in global bond markets. However in the last three weeks, the US benchmark 10-year bond yield has declined that much, reversing its previous rise. Indeed the same trend has been seen in other major markets, if not to the same extent. 

Why did bond yields not continue their advance towards 2% yields? Why have bond investors re-assessed the situation? It is easier to explain in the context of Europe and the UK than in the States. 

Across the EU, further lockdowns, reflecting the continued slow rollout of vaccinations, are affecting economic statistics this spring and expectations for economic growth in the coming year. For example, the consensus forecast for German GDP growth in 2021 has declined to about 3.5%, some 0.5% lower than the estimates which were being made in January. That is despite the fact that Germany is clearly benefiting from the uptrend seen in global trade; the economic forecasts for many other European countries are not as positive. On top of these macro fundamentals, the ECB has also stepped up its bond purchases to help restrain the market. 

Turning to the UK, it is clearly good news that the government is easing lockdown restrictions. The much-anticipated return to the High Street, and indeed the return to full-time education, will contribute significantly to GDP growth. Surveys report that CFO optimism is at record levels However it is still the case that the economy has suffered major losses during the pandemic. Output is broadly about 8% lower than a year ago, and even with a rapid recovery in coming months the general expectation is that GDP will not return to its pre-pandemic level before the middle of next year at the earliest. Feed such estimates of spare capacity into any econometric model and it will spit out the result that inflation will be restrained for some time to come.

The situation does appear different in the USA. Economic forecasts are being revised higher with every passing day, as Biden tries to light the after burners of government spending. GDP is expected to rise 6-7% this year, the fastest since 1984. The latest inflation data has begun to show the much-expected rise in headline inflation, partly reflecting supply chain disruptions over the pandemic but especially rising food and commodity prices, notably sharply higher energy costs from a year ago. Headline inflation in March reached 2.6% pa and forecasts are for a peak of 3-4%. 

However time and again, Fed officials have made it abundantly clear that they are willing to look through this transitory increase in headline inflation. One argument is that disinflationary forces will be in place for some time to come, i.e. a flatter Phillips curve than in the past. The Fed can point to core inflation in the States having been steady about 1.5% a year. Business surveys report a lack of pricing power by small and mid-sized companies. Another argument is that it is now the Fed’s aim to allow the economy to run hot in order to bring unemployment down, especially for the minorities. The bond markets and the money markets are more convinced by the day that whilst some tapering of QE might be seen in the first half of 2021, the first move higher in US interest rates is unlikely before the end of next year. 

However that is a long way away for a bond investor, and indeed currency markets where the dollar is once again seeing selling pressure. Inflation goes in cycles, so the key issue for markets and the Fed – indeed all central banks – may be in 9-12 months. Then the jury which is the market place will examine the underlying drivers of inflation – wages, productivity, unit labour costs, accommodation, healthcare – and reach a decision on whether inflation pressures are becoming entrenched and inflation expectations becoming unanchored. 

Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial matters and should not be considered as financial advice in any form.