Munix Weekly 17th June 2022
Accelerating away
Bond markets have become rather volatile. Although the benchmark US 10 year bond yield is about 3.25% at the time of writing, it lurched towards 3.5% in recent days. A daily change in the 2 year US bond yield was the highest since 2009. Investors are attempting to understand the real economy impacts of surprise moves by central banks. Central bankers are worried that inflation is accelerating away. Certainly they don’t want to see any further acceleration in inflation expectations. Hence, this was the week where we saw an acceleration in monetary tightening.
On Wednesday, the US Federal Reserve raised interest rates by 0.75%, its largest move since 1994. The accompanying press conference strongly signalled more to come. The Fed’s own projections show that it plans to raise rates by an additional 1.75% before the end of the year. This would be the most aggressive pace of tightening since Paul Volcker engineered a recession to tame inflation back in the early 1980s.
Until a few days ago, the markets had expected the US to raise interest rates by 0.5% this week. Central bankers change their minds when they see sufficient new evidence. The unpleasant surprise was last week’s CPI report, both a little worse than expected (8.6% in the year to May) and containing some worrying components. The Cleveland Fed analysis suggests that upward pressures remain broad-based. The Atlanta Fed’s measure of core inflation is the highest in three decades. The University of Michigan’s survey of long-run inflation expectations jumped to 3.3%, having been stable at 3% for four months. Market expectations (breakeven rates on 10-year Treasury Inflation Protected Securities) are still higher than the Fed would like to see at 2.7%.
The speed of the turnaround in monetary conditions is notable. Six months ago, only two FOMC members thought US interest rates would even top 1% this year. Now, there is unanimity that it will surpass 3%. Market projections are that the peak in US interest rates will now be between 3.5-3.75%.
Of course the Fed has to suggest that it can engineer the fabled soft landing for the economy. Hence, its economic forecasts suggest that GDP growth will only slow to 1.7% in the year to Q4 2022, and similar in 2023, causing unemployment to rise by only 0.5% to 4.1% by 2024. This contrasts with warnings that the US economy will tip into a recession next year, according to nearly 70% of leading academic economists polled by the Financial Times. In Chairman Jerome Powell’s press conference, he hinted that headline inflation would figure more in the Fed’s thinking than core inflation, albeit this may be more of a political sop in view of growing Congressional and public criticism of the Fed. Rate increases are also front loaded. The median Fed projection showed only modest hikes in 2023 and nearly all participants expected rate cuts in 2024.
Sometimes central banks prefer to write in bureaucratic terms. “The Governing Council decided to mandate the relevant Eurosystem Committees together with the ECB services to accelerate the completion of the design of a new anti-fragmentation instrument for consideration by the Governing Council.” In simple terms, the ECB has become seriously concerned that peripheral European bond yields are too high; this week Italian yields have reached 4%, 2.5% above German rates when a few months ago the gap was only 1%. Greek 10-year bonds are back at a four-year high. The higher cost of borrowing not only put pressure on weaker highly indebted European economies but revived unfortunate memories of the Euro financial crisis a decade ago. The very fact that the ECB took the unusual step of meeting outside their regular meeting cycle is evidence that the bank takes the situation seriously.
Whilst the market’s immediate reaction was one of relief, and yields narrowed accordingly, the ECB faces an increasingly complex summer. It is still expected to raise interest rates in July and September, perhaps by 0.5%, and begin to reduce its bond purchases. Now the markets will also watch and wait with eager anticipation for details of the new ‘anti-fragmentation tool’ to control the widening of sovereign bond spreads, and whether it looks practicable. Over the last two weeks, the money market has doubled its projections for the ECB’s base rate by next February from 0.7% to 1.6%.
Although the official mantra from the Bank of England was ‘steady as she goes’, pressure is growing on the authorities to accelerate. The MPC took rates up from 1% to 1.25%, its highest level since 2013. However, 3 of its 9 members argued for a move of 0.5%. Financial markets now expect base rates to reach 3% by the end of the year, and have adjusted the peak level of interest rates closer to 3.5%. The Bank has once again been forced to admit that inflation will be worse than it had expected. As recently as November, the Bank was predicting inflation would stay below 5% and have begun to fall by now. Now it warns that headline inflation could reach 11% in October following the next increase in the energy price cap. The Bank will also watch warily the depreciation in sterling, which at one point threatened to go below 1.20 versus the dollar.
The Bank of England increasingly finds itself in a quandary – stagflation has appeared. The Office for National Statistics reported that GDP fell 0.3% in April, down for a 2nd successive month. There are special factors – GDP was restrained by the ending of free Covid testing by the government, whilst in in May industrial production will be affected by the extra bank holiday to celebrate the Queen’s Jubilee. Economic data is mixed. The jobs market is tight, yet consumer confidence is low. Mortgage arrears have crept up to a 12 year high. Tax bills are rising but the Chancellor has announced increased benefits. Indeed one reason the Bank needs to act is its assessment of the fiscal support program provided by the government last month: “these measures were likely to boost GDP by around 0.3% and raise CPI inflation by 0.1% in the first year, with some upside risks around these estimates given the targeted and front-loaded nature of some of the measures”.
Over 45 central banks have tightened monetary policy so far this year. Central banks are surprising markets, by the size of the moves, by arranging emergency meetings, by paying more attention to currency changes and financial conditions as well as real economy data. All in all, central banks are recognizing that they have little choice but to try to lower demand back into line with diminished supply, against a backdrop where large parts of the complicated processes creating inflation lie outside their control – most notably oil prices up more than 60% from a year ago. Central banks may need to go into over-drive to calm down inflation expectations before the peak of the rates cycle can be seen.
Bond yields at the time of writing this week and one month change
% 2 year 5 year 10 year
USA 3.17 (+0.45) 3.33 (+0.32) 3.24 (+0.25)
UK 2.06 (+0.63) 2.14 (+0.57) 2.50 (+0.60)
Germany 1.11 (+0.86) 1.49 (+0.76) 1.67 (+0.63)
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