The calm before the storm
It is well known that the jet stream directs the weather across the Atlantic. Hence hurricanes on the east coast of America eventually appear as storms for Europe and the UK. So it is with the business cycle and monetary policy decisions.
After a period when US bond yields had fallen a long way – down from 1.7% to 1.2% since April on 10-year Treasuries – there has been a noticeable turnaround in recent days with yields back up towards 1.35%. The stars were aligned as a series of warnings from US policy makers combined with several major economic reports showing the strength of the US economy and continued inflationary pressures.
The first of the reports looked at the state of employment. Analysis shows that these statistics have the greatest ability to move the markets of any of the stream of economic data released in the USA each month. In July, the US continued to benefit from the opening up of many services sectors. Hence, payrolls rose by almost 1 million jobs, taking the unemployment rate down past 5 ½ percent Company surveys have reinforced an important point, that many companies are finding it difficult to get suitable staff as they open up or expand their operations. There is a mis-match between where and how people want to work and which industries are hiring. Hence, another sign of inflation was that wages are growing at an annualised rate of about 5%; there have been some signs of wage-price pass-through too, with sizable gains in restaurant, recreation services, and healthcare prices.
Such inflation worries were reinforced by the latest consumer prices report for July. The good news was that headline inflation remained steady, albeit still up 5.4% from a year earlier. Many of the special factors which have boosted inflation in recent months, for example in second hand car prices or airline fares, showed signs of peaking or rolling over. However, deeper analysis of the report, and other business surveys, does suggest that the deceleration in inflation will be moderate into 2022. Housing costs for example are on a clear uptrend. Indeed some economists are forecasting that core inflation, that is excluding volatile food and energy components, might only ease from 4.3% a year at present to 3.0-3.5% by end 2022. Surveys of consumer inflation expectations have responded; median expectations in three-year’s time have reached 3.7% on New York Fed measures.
Against this economic backdrop, the Federal Reserve governors did their best to put a floor in the bond market and steer yields higher. For example, Bullard said the Fed should begin trimming its monthly bond purchases soon and be ready to raise interest rates if inflation does threaten to remain too high for too long. Clarida said he feels the conditions for raising interest rates could be met by the end of 2022 and could certainly see the Fed start tapering its QE programme later this year. Kaplan said reducing QE soon would lay out the groundwork for a more “patient approach” to raising borrowing costs. Similar phrases flowed from the lips of Daly, Bostic and Rosengren, although Barkin and Evans were a little more circumspect about room for the job market to heal.
At the end of that series of announcements, the money markets are fully pricing in an interest rate move by the Fed by end 2022. The consensus amongst economists is that the Fed will debate tapering its QE purchases in September and act in December, with possibility of moving earlier rather than later if the economic data surprise.
UK gilt yields have moved higher across the curve, not by large amounts but then the winds of change from across the Atlantic are still moderate. The faster the UK economy grows, the tighter labour market, the greater the second-round inflation pressures, then the sooner the MPC will
follow in the Fed’s footsteps. For example, after the surge of 4.8% in GDP growth in the second quarter in the UK, consensus forecasts are for rather slower expansion of only 1.5% in the third quarter. More rapid growth would mean that spare capacity is being used up more quickly, spurring on higher gilt yields too.
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.
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