Are we there yet?
On a long car journey, children often ask “are we there yet”. Impatient investors, politicians and journalists frequently ask the same breathless question, looking for sharp improvements in trends when the very nature of the world economy means that it will take time for changes to be seen.
Are we there yet in terms of the peak in inflation? Probably, on the key assumption that the Ukraine war does not take a major turn for the worse and lead to another surge in food and energy prices. UK CPI rose 9% in the year to April; it may edge higher in the next month or two, and will rebound in October when the cap on energy prices is adjusted again. However, an erratic downward path is likely into 2023 – the problem for all policy makers is that the pace looks to be rather slow, not reaching central bank targets until the end of 2023 or into 2024. Such a view is based on some valiant assumptions that the labour market does not produce surprises in terms of future wage increases. In the UK, there are now more vacancies than there are people looking for jobs for the first time on record.
Central bankers are watchful and wary. Hence, US Fed Governor Loretta Mester warned that inflation will need to move lower for “several months” before the Fed can safely conclude it has peaked. She was blunt with some of her remarks: “If by the September meeting, the monthly readings on inflation provide compelling evidence that inflation is moving down, then the pace of rate increases could slow, but if the inflation has failed to moderate, then a faster pace of rate increases may be necessary”.
As the ‘cost of living crisis’ becomes ever more front page news, so the pressure grows on politicians and central bankers to ‘do something’. Governor Andrew Bailey and other MPC members faced harsh questions from the Treasury Committee this week. From an economic viewpoint, most of the current rise in headline inflation is outside the control of central bankers – after all energy on its own equates to about 3.5% of the 9% inflation rate. Nevertheless, there is a risk that central bankers decide to become more aggressive to bear down on inflation expectations. We saw several examples this week. Dutch central banker Klaas Knot talked about the prospect of raising rates by 0.5% rather than 0.25% in June. Together with some hawkish minutes from the ECB, markets have adjusted towards the ECB tightening policy by a full 1% by year end.
Whether or not central banks are aggressive, bond markets are also pricing in a more downbeat economic outlook for the major economies. Although economic data in the USA, UK and Europe have held up in April, China reported a slump as parts of the country were locked down. Concerns are growing about weak global growth as pressures grow on supply chains and inflation bites into household and business incomes. The Institute of International Finance cut its global growth forecast to only 2.2% this year. Next year looks little better, as the European Commission expects the EU to grow by 2.3%, while Goldman Sachs expects the US to expand by 1.6%. Recession fears are also rising. Admittedly, most surveys of economists suggest that it is only a 1 in 4 or a 1 in 3 probability. However, all such forecasts are fraught with uncertainty. How will the war affect future energy supplies? How long will the lockdowns occur in China and what does this mean for global trade? What is the ability of Ukraine to export food through Europe to Africa and the Middle East? Put more simply, is Fed Governor Charles Parker correct that “this economy can withstand a measured, methodical approach to tightening financial conditions”?
Bond yields have oscillated this week, for example between 2.8% and 3.0% for the benchmark US 10 year yield. A key factor has been the waxing and waning of views about the state of the stock market, on course to suffer the worst falls since spring 2020 as profits come under pressure. Putting aside such short term volatility, the table at the end of this note shows some interesting developments. The only market to demonstrate a significant rise in yields in the past month was Germany, reflecting that hawkish ECB talk. Otherwise US bond yields are broadly unchanged whilst gilt yields have fallen back marginally on the month. Indeed the expected peak in interest rates in 2023 has edged lower in both countries. So, are we there yet in terms of the peak in bond yields in such countries? Sadly the driver of the car is not yet certain where they are on the route – foggy conditions still lie ahead.
Bond yields at the time of writing this week and one month change
% 2 year 5 year 10 year
USA 2.62 (+0.05) 2.86 (-0.01) 2.85 (+0.02)
UK 1.51 (-0.06) 1.62 (-0.04) 1.91 (-0.02)
Germany 0.38 (+0.032) 0.70 (+0.11) 0.97 (+0.11)
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