MUNIX WEEKLY 25th March
Jaw, jaw is better than war, war
The famous quote from Winston Churchill sadly has rather more relevance to policy makers in the West than the representatives of Russia and Ukraine as peace talks appear to sink into a morass. In a week when there was little major economic data or news from the war, so bond investors had a spate of speeches from central bank governors and finance ministers to listen to – and fine tune their expectations about the future path of monetary policy. The net result was further pain in terms of higher yields and lower prices across most fixed income markets.
First and foremost amongst the statements was the Chair of the US Federal Reserve. The following quotes will give a flavour of his more hawkish views: “Inflation is much too high. We have the necessary tools, and we will use them to restore price stability”. “There is an obvious need to move expeditiously to return the stance of monetary policy to a more neutral level, and then to move to more restrictive levels if that is what is required to restore price stability.” Backed up by speeches from fellow governors such as Bullard and Mester, the markets decided that the Fed would be even more aggressive in terms of raising rates this year. The consensus seems to be building for a 0.5% rate hike in May, whilst analysts expect to see a cumulative increase of 2.25% by year end.
The divergence is becoming more noticeable between the USA and UK on the one hand and Europe and Japan on the other. Christine Lagarde at the ECB commented that the (relatively stronger) US and (relatively weaker) EU economies and thus central bank policies will increasingly move out of sync. Bank of Japan Governor Kuroda said Japan must maintain an ultra-loose monetary policy, also highlighting the widening gap with the Fed’s tightening stance. The net result has been seen in a stronger US dollar versus these other currencies.
Last but not least amongst this week’s announcements was the UK Chancellor’s spring statement. He rather fell between two stools, not giving enough to compensate for the hit to household incomes, nor enough to kick start a slowing UK economy. Most newspaper headlines understandably focused on the OBR’s projection that inflation will lead to the biggest fall in living standards since records began in the 1950s. On balance, however, the Bank of England will assess that fiscal policy is tightening rather than easing, which means UK interest rates need not rise as markedly as in the USA this year. In effect Sunak only undid about 1/6th of the tax rises he had previously announced. Such tax increases and restrained public spending means government borrowing as a percentage of GDP is forecast to fall to about 5% this year, 4% next year, and 2% the year after. The Chancellor needs to keep a watchful eye though on surging debt interest spending, forecast to reach £83bn next year, nearly four times last year’s total of £24bn. Higher interest rates and higher inflation are an unpleasant combination for government finances.
Some economic data was released this week and did have a modest impact. The UK CPI came in worse than expected up 6.2% in March from a year ago. Forecasts for a peak in April are running just over 8%, although economists are fine tuning their views with every move in the oil price. Brent crude rose once again past $120 per barrel on news that Russia was reducing supply through an important pipeline, supposedly to give time for repair after storm damage. As one economist said, “We are in a twilight zone between the real-time shock of Russia’s invasion of Ukraine and its appearance in the macroeconomic data”. The earliest surveys of commercial activity in March showed only a modest hit so far from events in Ukraine, negative for manufacturing but positive for services still benefitting from the end of covid lockdowns. Next month’s data may give a rather different picture. After all, business confidence and household sentiment has unsurprisingly been hit hard by the war whilst business surveys reported a historic rise in costs for parts and raw materials. The German Ifo survey has fallen to its lowest level since January 2021.
Economists are trying to assess what the impact of Russian sanctions, disrupted trade, higher commodity prices and tighter monetary policy will be. The debate is growing about whether the fabled ‘soft landing’ will result. Bodies such as the IMF are warning about the scale of the dislocation to global food systems and its impact on low income households in most countries. On balance, downgrades to growth and upgrades to inflation remain moderate. IN the UK, for example The Office for Budget Responsibility (OBR) said the UK was likely to grow by 3.8% this year, versus the 6% forecast which the OBR made in October. Perhaps more importantly the OBR lowered its growth forecasts for 2023, 2024 and 2025 to only 1.8%, 2.1% and 1.8% respectively – a slow growth world at best. The OBR expects inflation will average at 7.4% this year, up from its autumn forecast of 4%. It comes as no surprise therefore that authorities such as the National Institute of Economic and Social Research warn that UK growth risks grinding to a halt. “At current energy and oil prices, the UK is skirting very close to a fall in activity. We’re going to be hovering around zero next year”.
In the short-term, bond markets are paying more attention to prospects for higher inflation than eventually weaker growth. The extent of the rise in yields should not be under-estimated. The US Treasury market is experiencing its worst month since 2016. The yield on the US 10-year bond is about a full percentage point higher than it was just six months ago. Yields in the UK and Germany have reached or are approaching levels last seen back in 2018 before Covid began. The combination of a strong dollar, rising oil prices, less generous fiscal transfers and higher interest rates will undoubtedly weigh on economic growth in late 2022 and into 2023. Hence, alongside moves in benchmark yields, analysts are also paying close attention to the shape of the yield curve. Curve flattening has been relentless – down to a gap of only about 0.2% between 2 and 10 year US Treasuries. An inverted curve would be an important signal that stagflationary fears are growing apace, indeed that the US might be entering recession in 2023-24. Since 1978, there have been six US recessions and on average the yield curve inverted about 12 months before each one occurred. Caveat emptor!
Bond yields at the time of writing this week and one month change
% 2 year 5 year 10 year
USA 2.15 (+0.57) 2.38(+0.52) 2.35 (+0.38)
UK 1.31 (+0.10) 1.37 (+0.12) 1.60 (+0.14)
Germany -0.22 (+0.16) 0.24 (+0.24) 0.49 (+0.28)
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