Time for a rest, then a busy 2023
A few financial markets remain open over the Christmas and New Year holidays, but the majority of traders and investors will take a well-earned break. After all, 2022 has been a year of considerable volatility. Short-term interest rates in the UK have risen from close to zero to 3.5%, and the benchmark 10 year gilt yield has ranged between 1% and 4.5%. Some days have seen historically high movements in gilt prices; on one measure, the MOVE index, bond market volatility is running at nearly twice its average over the five years to February 2020, when the pandemic first shocked markets. After a restful holiday, many will hope that 2023 includes rather fewer surprises.
The past week included important central bank announcements from the Bank of England ,the Federal Reserve and the ECB. There were no major shocks, all moved rates higher by 0.5%. However, the tone and commentary from Bailey, Lagarde and Powell in their statements to the press led to divergent moves in bond yields across the three markets.
The Fed updated its economic forecasts for 2023, and to quote one commentator “the Federal Reserve delivered a hawkish 0.5% rate hike, signalling rates will be increased and kept at 5.00-5.25% in 2023 via its dot plot projections and verbally pushing back against speculation that inflation is on a sustainable downward path just yet”. Powell emphasised the “very strong” labour market, which mattered considerably for ‘non-housing related core services’ inflation, and produced a model of inflation that implied more tight money was needed. The Fed’s view differs from the market – it does not expect rate cuts in 2023 but only in 2024, when the benchmark rate is projected to decline to 4.1 per cent before falling to 3.1 per cent in 2025.
The ECB moved by 0.5% but in a rather hawkish manner as it warned of more to come. After all, it expects inflation to be above target for some time to come; its latest forecasts show inflation averaging 4.2% in 223, 3.4% in 2024 and 2.3% in 2025 despite a sustained period of weak economic growth. Christine Lagarde was very clear: “Anybody who thinks that this is a pivot for the ECB is wrong. We should expect to raise interest rates at a 50 basis-point pace for a period of time. Keeping interest rates at restrictive levels will over time reduce inflation”. Markets think another 1% on rates is likely in the first half of next year.
The ECB’s statement about its intentions to run down its balance sheet of bonds might be of more interest than the rate decision. After all, government debt issuance will be high in coming years. Reuters estimates that the cumulative scale of German bailouts and schemes the Berlin government has launched to prop up its failing energy system this year is now €440bn, or about 12% of GDP. The bank announced it would start to reduce its bond portfolio, that is the process of quantitative tightening, from March 2023 onwards.
The Bank of England may be closest to pausing on rate hikes, partly reflecting the weak state of the UK economy of course. Its decision to raise rates by 0.5% was coupled with signs that the Committee is prepared to move more cautiously over coming months. The MPC outcome split three ways: six members including Bailey voted for the half-point rise, Catherine Mann favoured three-quarters of a point, while Silvana Tenreyro and Swati Dhingra backed leaving rates unchanged. The Bank has warned in its six monthly Financial Stability Report about significant pressure on households and businesses due to higher inflation and borrowing costs. “Falling real incomes, increases in mortgage costs and higher unemployment will place significant pressure on household finances”.
The economic data held few surprises in the run up to Christmas. Consumer spending remains muted, no surprise as households prepare for large energy bills in coming months. Some parts of the inflation pipeline are rolling over, such as the cost of petrol, whilst the St Louis Fed’s Price Pressure Index fell in November to reach its lowest level since October 2021. However, other parts of the inflation pipeline still show pressures. While unemployment has edged higher, to 3.7% in the UK for example, strikes for higher pay are a feature of many countries. Rather concerning for the Bank of England was the news that wage growth has accelerated, with overall basic pay up 6.4% year on year in October. In the short term, headline inflation is rolling over faster than the core rate of inflation. In the USA, the headline rate has fallen to 7.1% and the core to 6%. The UK has seen a similar but flatter path, down to 10.7% and 6.3% respectively in the year to November.
2023 holds much uncertainty – the state of the war in Ukraine, the choices made by President Xi between an economic crisis and a health crisis, whether a soft landing appears for the global economy, how bond investors react to much higher debt issuance whilst central banks continue withdrawing their support. With a moderate recession looming, bond market investors generally expect rates to peak in the spring of next year and then start to fall in the second half of 2023 – despite protestations to the contrary from central bankers. It should be emphasised, however, that even the forecast peak level, about 5% in the US, 4.5% in the UK, and 3% in the EU, masks a wide range of views. One survey showed a fifth of respondents expected ECB rates as low as 2.5%, whilst an equal number expected 4.0-4.5% by end 2023. The outcome will depend on the accuracy of inflation forecasts, which have not been great in 2022. Last year, economists surveyed by Bloomberg expected that so-called core index to fall to 2.5% by the end of 2022. Instead, it is running at 5 percent.
As we end the year, various aspects of the bond markets stand out. The US yield curve has reached its most inverted point since 1981. Interest rate expectations differ significantly between what central bankers are talking about and what is priced into market expectations, a tension to be resolved at some point in 2023. Bond market investors face a configuration not seen for decades, a policy-engineered slowdown in the world economy against the backdrop of a large and sustained rise in inflation and massive government bond issuance. The coming year looks to be an interesting one.
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 4.25 3.64 3.48
UK 3.47 3.31 3.32
Germany 2.44 2.25 2.17
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