Munix Weekly 24 June 2022
Listen carefully, I will only say this once
In spy thrillers, James Bond and Mission Impossible type action movies, the hero only has one opportunity to listen to an important message. In the real world of central banking, there are multiple opportunities for messages to be circulated to investors, fine-tuned and re-sent again.
Such was the case this week when Fed Chair Jerome Powell gave his semi-annual Congressional testimony, firstly to the Senate and then the House of Representatives. Bond investors were rather more pleased than equity investors by what they heard.
Powell made it clear that the Federal Reserve is now focused on attaining its target of 2% inflation and will do what is necessary, that is taking rates much higher, to get there. He urged that the Fed will make “continued expeditious progress toward higher rates,” and noted “financial conditions have already priced in additional rate increases, but we need to go ahead and have them”. The worrying words for equity investors were the admission that “We are not trying to provoke, and I don’t think we will need to provoke, a recession”, although he acknowledged that one was “certainly a possibility”.
This week’s economic data made such a recessionary outcome appear more likely. It was the case that inflation reached new highs – notably in the UK the CPI report edged higher to 9.1% in the year to May, with the Bank’s warning of 11% by the autumn still ringing in everyone’s ears. However, a stream of statistics rather suggest that economic activity is starting to roll over. Business surveys such as the Purchasing Managers index for the developed economies showed a steep deceleration in the services sector (down 3 points to 52.5) and a broad-based moderation in manufacturing (down 2 points to 52.5). A range of 45-50 is traditionally the zone in which recessions start to appear. This chimes with a few other reports. The Chicago Fed economic activity index looks on the verge of going negative. Global consumer sentiment hit the lowest level since the financial crisis. This explains why surveys of economists report growing numbers suggesting that recession lies ahead in 2022-23.
The Fed was far from alone in speaking and fine-tuning its message this week. Christine Lagarde at the ECB, Philip Lane, its chief economist, and other members were at pains to reinforce the message that the bank would move by 0.25% in July – and could move more aggressively later in the summer depending on whether the economy was strong enough to withstand the pain or inflation was bad enough so require further action to quell underlying pressures. In the UK, Catherine Mann repeated her call for interest rates to rise by 0.5% at the next meeting, whilst Huw Pill indicated that policy makers would sacrifice growth in order to bring down inflation in the UK, saying there is otherwise a risk of prices developing a “self-sustaining momentum.”
The market is still pricing in major rate hikes in the summer. Indeed if its estimates are correct, 2022 will witness the sharpest tightening of monetary policy since the 1980s. However, projections for the terminal or end rate for this interest rate cycle have fallen back; in essence bond yields in the UK, USA and Europe declined as at least one interest rate move has been taken out of the cycle. Some of the resulting moves were rather noticeable. At one point, the 30-year UK gilt yield reached 2.8%, the highest level since 2015, before falling back to 2.56% at time of writing.
It is worth ending with a quote from a long time Fed watcher, Bill Dudley, former governor of the New York Fed, who said “If you’re still holding out hope that the Federal Reserve will be able to engineer a soft landing in the US economy, abandon it. A recession is inevitable within the next 12 to 18 months”. If that is the case, then the shape of the yield curve becomes even more important to monitor. As and when we start to see longer-dated bond yields falling more than shorter-dated ones so the recession narrative gains more traction. For now, the spread between 2 year and 10 year bond yields remains modestly positive.
Bond yields at the time of writing this week and one month change
% 2 year 5 year 10 year
USA 2.95 (+0.32) 3.09 (+0.21) 3.04 (+0.18)
UK 1.94 (+0.37) 1.94 (+0.27) 2.30 (+0.33)
Germany 0.80 (+0.39) 1.16 (+0.42) 1.42 (+0.41)
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