MUNIX WEEKLY
‘Sticks and stones can break my bones, but words will never hurt me’
I have never been sure about the wisdom of this childhood chant. Although the U.S. Federal reserve did not raise interest rates this month, the tone and tenor of accompanying statements certainly hurt the markets, as worried or frightened investors quickly altered their portfolios. On top of political worries about the situation in the Ukraine, financial markets are showing considerable volatility.
One of the headlines in the run up to this month’s Fed meeting was “Bold policy response needed to restore Fed credibility on inflation”. In the event, rates were not changed whilst QE bond purchases will continue for a few more months. However, the markets paid great attention to the words of wisdom from Fed Chair Jerome Powell during his press conference. He spent a lot of time discussing the strength of the labour market: ‘the majority of the board, and I myself, believe that the economy is today at the maximum level of employment consistent with stable prices’. He also appeared concerned that high levels of inflation would persist. Money markets reacted by fully pricing in four, possibly five, Fed hikes this year, starting in March. 2-year bond yields rose 13 basis points during and immediately after his press conference, one of the largest one-day rises since the Great Financial Crisis, taking yields to their highest level since February 2020.
Whether four or five is the right number is actually outside the Fed’s control. Much of today’s US excess inflation relates to fuel and used car prices, neither directly affected by Fed policy. Another domestic inflation driver would be serious wages pressure, so we watch with great interest next month’s employment report, but external drivers could include a crisis in the Ukraine resulting in much higher energy prices. Some analysts are already warning of oil prices rising from about $85 towards $100 a barrel due to tight supply and demand conditions. Nevertheless, financial markets remain convinced that ultimately the Fed will be on top of the situation; forward looking inflation measures remain contained.
Turning to the UK, bond markets followed the direction given by the USA. They are not paying much attention to domestic politics. Even if the Prime Minister is forced to resign, his likely successors are seen as a safe pair of hands meaning no dramatic changes to policy making. Meanwhile the economic data means that the probability of an interest rate increase at the February 3rd MPC meeting remains around 90%. January’s upbeat UK purchasing managers survey was the latest piece of evidence that Omicron’s economic impact has been relatively mild. Despite the sell-off in stock markets, the Bank of England is still likely to move in February unless a major shock such as the situation in the Ukraine worries policy makers. The only other major item for the MPC to take into account is whether the Treasury takes some action to offset the approaching tsunami on household finances from higher national insurance contributions and energy bills. UK public sector borrowing dropped more than expected in December, thanks to improved tax revenues and savings in public spending as the economy recovered. Borrowing for 2021 was still as high as £147 billion, but this was £129bn lower than the previous year.
Central banks are at a significant turning point, pulling back from historically ultra-easy monetary policies. Understandably they face criticism from all sides: some critics want to protect businesses and households still in serious trouble, others suggest maximum flexibility in light of so many competing factors affecting inflation, still more are worried that policy makers are lagging well behind economic realities, or have helped create asset price bubbles. We can expect many more days of market volatility until the situation is resolved.
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