On your marks, get ready …….wait for it……
As 2023 gets under way, tensions are apparent between current economic data and central bank predictions about the future. In particular, the course of the bond markets in 2023 will depend on whether central banks or markets have better foresight on inflation.
What is in the price? Investors and analysts currently expect further monetary tightening, with interest rates up to about 5% for the US by the summer, alongside peaks of 4.5% in the UK and 3% in Europe. After that the consensus view is a significant easing cycle over the following two years to leave rates about a neutral level of 2-3% into 2025. A marked slowdown in the world economy supports such a view. For example, the World Bank has lowered its forecast for global GDP growth to only 1.7% this year. Indeed it suggests that average growth of under 2% across the period 2020 – 2024 would be the lowest since 1960.
Clearly this view will alter in the light of new information, such as energy prices responding to Ukraine developments, or climatic shocks, or a major turnaround in the Chinese economy once the current wave of Covid has washed through the country potentially opening the way for President Xi to announce much easier monetary and fiscal policies.
What is the current data telling us? There are further indications that inflation has peaked – the latest inflation figures for the USA showed headline CPI down to 6.5% and core CPI running at 5.7% from a year ago. Another helpful report was average earnings growth easing towards only 4.5% a year – surely the fabled soft landing is in sight! However, other data gave some warning signs. The US economy ended 2022 on a strong note. The Atlanta Fed estimates Q4 GDP growth back near 4%., while there are few signs that the labour market has come under any serious pressure. As ever, weak business surveys, from the ISM or the NFIB, can be interpreted as signalling more about current gloomy sentiment than necessarily suggesting imminent sharp cuts in staff, investment, or other costs.
This helps explain why the Fed remains in hawkish mode. The latest set of minutes of the Federal Reserve included a lot of protestations about rates needing to stay high until inflation convincingly declined. “Once we achieve a sufficiently restrictive federal funds rate, it will need to remain at that level for some time in order to restore price stability, which will in turn help to create conditions that support a sustainably stronger labour market” and hence “No participants anticipated that it would be appropriate to begin reducing the federal funds rate target in 2023”. Subsequent to the minutes, Michelle Bowman said the central bank will have to raise interest rates further to combat inflation which will lead to a softer job market. “Inflation is much too high; while inflation may have come off the peak, we have a lot more work to do”. The only good news was more of a recognition that rates need no longer move in 0.5% blocks; Raphael Bostic said that if inflation cools then he would have to take a quarter point increase “more seriously and to move in that direction”.
Elsewhere, European bond markets were reassured by further signs that inflation did peak at the end of last year. Lower energy prices, especially for petrol, enabled EU CPI to fall back to 9.2% in the year to December from its peak above 11%. However, there are still wage pressures in the economy whilst the overall labour market remains rather tight. Certainly the ECB gave little sign that it wishes to change tack. Christine Lagarde indicated borrowing costs must increase to temper rising prices: “it would be even worse if we allowed inflation to become entrenched”. She was joined by a long list of colleagues during January; Joachim Nagel warned that there has been “a significant increase in long-term inflation expectations”; Mario Centeno said the ECB has no alternative but to raise rates until inflation is on a sustainable path to its 2% target; borrowing costs must be lifted much further, according to Isabel Schnabel, as “Inflation will not subside by itself”. Pablo Hernandez de Cos reiterated “keeping interest rates at tight levels will reduce inflation by dampening demand and will also protect against the risk of a persistent upward shift in inflation expectations”.
Closer to home, Huw Pill, the Bank of England’s chief economist, gave a major speech about monetary policy at the start of the year. He warned that the economy is at risk of persistent inflation from a tight labour market even if gas prices stabilise or fall. Although he was reassured that Britain was “starting to see labour market indicators turn” as job vacancies fell from record levels and unemployment edged higher, “the longer that firms try to maintain real profit margins and employees try to maintain real wages at pre-energy price shock levels, the more likely it is that domestically generated inflation will achieve its own self-sustaining momentum”.
Such a speech was made despite a backdrop of continued weakness in the UK economy, which is expected to last most of 2023. Manufacturing is under pressure; the CIPS purchasing managers’ index showed the lowest reading since the early stages of the pandemic. The Recruitment & Employment Confederation found vacancies rose at the slowest pace since February 2021, and pay growth was the softest in 20 months. British Retail Consortium data for December showed falling sales volumes. However, the deeper seated problem facing the Bank is that about one in 12 working-age adults in Britain has a long-term health condition and is not working or looking for work, a phenomenon that is straining the economy. Where next for wages against that backdrop, plus the widespread series of public sector strikes?
The consensus view has waxed and waned a little since the start of the year, but there have been no major shifts. UK yields are little changed over the past month, European yields are a little higher, US yields a little lower for short-dated bonds, a little higher for longer dated debt. The key question certainly seems to have moved on from whether inflation will cool to how fast the rate will come down, but there are many imponderables before investors can become too enthusiastic. Ready, Steady, Go?
This newsletter will also take a Christmas break and re-start in mid-January.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.17 3.62 3.55
UK 3.47 3.28 3.38
Germany 2.55 2.18 2.13
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