MUNIX WEEKLY 17 March
Don’t be distracted!
Financial markets faced a tsunami of information over the past week. The debate about whether or not Ukraine and Russia can reach a peace agreement caused considerable volatility in energy and commodity prices. There was significant news from China – covid lockdowns of large parts of the country led to worries about weaker economic activity leading to a stock market collapse, before a turnaround as the government promised to come to the aid of the markets. Economists are busy trying to catch up with events, leapfrogging each other as they raise their inflation and lower their growth forecasts to take account of sanctions, oil prices and China news. Political analysts write lengthy screeds about turning points in the global economic order, warning about the potential implications for trade, intellectual property and capital flows.
Nevertheless, central bankers in the USA, Europe and the UK remained focused on the task in hand – trying to bring inflation and inflation expectations back under control. Front and centre was the US Federal Reserve. Its first interest rate Increase since 2018 had been widely expected. However guidance from Fed officials, amplified by Fed Chairman Jerome Powell’s performance in his press statement, indicated that the bank expects to do much more – that it would be happy to raise interest rates by 0.25% at every meeting for the rest of the year. The Fed is keen to move in the face of an evident deterioration in inflation expectations. Gasoline approaching $5 certainly attracts public and political attention in America, its equivalent to worries about £2 per litre for diesel in the U.K. A hawkish approach is also warranted by more evidence of pricing power amongst companies. The Fed’s latest Beige Book stated: “Firms reported an increased ability to pass on prices to consumers; in most cases, demand has remained strong despite price increases. Firms reported that they expect additional price increases over the next several months as they continue to pass on input price increases.”
Similarly there were no surprises that the Bank of England raised interest rates once again. Although one member wanted to see more information about the impact of the Ukraine war on business and household confidence, the majority of the committee were more impressed by the strength of the labour market. Earlier this week the statisticians confirmed unemployment falling to a new low, amidst reports of 1.3 million vacancies. Wages are picking up albeit most households still face a squeeze on their living standards from increasingly expensive visits to petrol stations on top of the much publicised rise in gas bills and national insurance contributions. There have been warnings that Rishi Sunak will need to find an extra £10 billion if UK public sector workers are to avoid a painful pay squeeze in the year ahead. Whether the Chancellor tries to alleviate such pain in next week’s spring statement will be examined carefully by the MPC at its next meeting. The Bank already knows that a sizeable fiscal tightening looms – the question is how much.
The MPC must also assess where the oil price stands, so important for headline inflation. The Bank of England has admitted that the CPI could exceed 8% pa in the spring, with some bearish economists warning of 9% or more by the autumn. However the oil price has fallen back from its recent peaks of $120-130, partly on hopes for a peace settlement but also on the news of the slowing Chinese economy. By the time of the next central bank meeting there may also be more news about the success or otherwise of Messrs Biden and Johnson’s attempts to encourage Saudi Arabia, Iran and other Middle Eastern countries to raise oil production. It has been a long time since geopolitics and consumer inflation were so intimately linked.
The ECB did not meet this week, but various policy makers did make statements. On balance they were also on the bearish side, with Christine Lagarde warning about inflationary pressures and Klaus Knot even hinting that the bank might need to raise rates twice rather than once this year. While war in Ukraine will have a serious impact on EU GDP, the ECB feels it has no choice but to press on with policy normalization given the inflationary backdrop. A survey from Bloomberg showed growing pessimism amongst economists, with European Union economic growth downgraded towards 3.5% but CPI expected to be around 5% this year.
Amidst the mass of conflicting data and signals, bond markets have tried not to be distracted either, but focus on central bank actions and dovish or hawkish statements to guide them. It is noticeable that over the past week there has been little movement in UK gilt yields, whilst there has been an obvious upward trend in the USA and Germany. The fear for bond investors is that central banks suddenly realise that they have left matters too little, too late, that second round effects from wage increases and commodity prices begin to ripple through into core inflation. Jerome Powell did warn that interest rates might need to rise by 0.5% if the economy remained too strong. The Bank of England does expect to start actual sales of gilts once interest rates reach 1%. This period might eventually be seen as the calm before the storm.
Bond yields at the time of writing this week and one month change
% 2 year 5 year 10 year
USA 1.91 (+0.46) 2.15 (+0.33) 2.18 (+0.26)
UK 1.29 (+0.04) 1.33 (+0.04) 1.57 (+0.19)
Germany -0.35 (+0.10) 0.1 (+0.13) 0.38 (+0.16)
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