MUNIX WEEKLY
“Enough is enough”
The latest economic data certainly suggest that central banks will raise interest rates into the spring, and indeed they might become aggressive. For example the Office of National Statistics in the UK has reported continued strong demand for staff over the winter and also high wage awards despite further covid lockdowns. Hence, the markets are pricing in the strong probability that the Bank of England might move by 0.5% rather than 0.25% at a future meeting. US inflation and consumer spending reports are also buoyant. About one quarter of economists surveyed in the USA think the Fed will raise rates in March by 0.5%, even though the latest Fed minutes were more on the dovish side. US investors are pricing in the Fed funds rate reaching about 1.75% by December, compared with the current level of 0.25%. The debate about ECB policy continues apace but the prospect of a December 2022 rate rise implies ending the asset purchase programme in the autumn. More hints might be given at the next ECB meeting.
Nevertheless, unless there is war in the Ukraine and another surge in energy costs, then inflation should peak in the next few months. The Bank of England expects UK inflation, which was 5.5% in the year to January, to exceed 7% in April even with the Chancellor of the Exchequer’s recent package to support hard pressed households. A consensus view though would be a slow deceleration over 2022, accelerating lower next year once the energy price effects fall out of the calculations – on the key assumption of course that oil prices are stable!
Can we envisage a peak in the interest rate cycle then? That is certainly what parts of the bond market are signalling. The gap or spread between the yield on 2-year and 10-year government bonds is traditionally seen as signalling the medium-term outlook for an economy. A steep, upward sloping curve suggests strong growth and inflation pressures, whilst an inverted, downward sloping curve, that is shorter term yields are higher than those on longer dated bonds, suggests economic weakness, even recession ahead.
Where is the yield curve today? It remains steep but has certainly flattened. To give some detail, over the past 6 months the US 2-year bond yield has risen from about 0.2% to about 1.55% whilst the 10-year yield has moved from 1.25% to 2.0% over that period. Hence the spread has narrowed and is now about 0.5%. In UK terms, the 2-year gilt has similarly moved from 0.1% to 1.4% in the past 6 months, whilst the 10-year gilt yield has risen from 0.6% towards 1.5%. The spread is now only about 0.15%.
This suggests that investors, rightly or wrongly, consider that central bank actions will be sufficient in quelling inflation whilst only restraining economic growth modestly. Households agree; surveys of consumer inflation expectations appear to have peaked in most major economies. This matches another aspect of the money markets; short-term interest rate futures point to Fed rate cuts between 2023 and 2024, when economic activity is perceived to be rather weak after the bust-boom cycle of 2020-22.
A word of warning – financial markets are not always accurate! Academic research has shown that plotting historical 10-year Treasury yields against what the inflation rate actually turned out to be over the following five years showed considerable over-shooting and under-shooting. There are many moving parts to an inflation forecast, as the recent moves in oil and gas prices due to climate change and Ukrainian politics make abundantly clear.
Markets continue to face an abundance of signals, including economic data, central bank speeches, political and geopolitical uncertainty, which they try to price in with more or less success. Consequently, the shape of the yield curve as well as the change in official interest rates and the movements in the benchmark 10-year bond yield all need to be considered carefully, to see where the best entry and exit points may be for a fixed income investor.
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