MUNIX WEEKLY 29 April
Eddies, ripples, waves, and tsunamis
Water is a fascinating medium. Events many miles away can trigger waves which are transmitted across the oceans and cause considerable damage when they reach the shore.
Such was the outcome at the start of this week. The focus of market attention shifted from the worsening war in Ukraine to events in China. News that more cities were entering lockdown as the government attempted to restrict the spread of the Covid virus, following on reports that retail sales fell year on year in March for the first time since mid-2020, encouraged a rapid re-appraisal of the prospects for the Chinese economy, so important for the global supply chain of manufactured goods. A mini-panic rippled through global currency, equity and bond markets. As one example of the adjustment which took place in market expectations, last Friday investors anticipated the ECB would raise interest rates by about 0.85% by the end of 2022. By the middle of this week those expectations had dropped closer to 0.7%. This is despite EU inflation running about 7.5% from a year ago, while ECB officials expect to see it edge higher in coming months.
Another wave hit the UK gilt market from another direction, across the Atlantic. The statisticians estimated that the US economy unexpectedly contracted in the first quarter of the year, albeit there were special factors affecting overseas trade and stocks of goods & raw materials, whilst domestic demand remained quite robust. Nevertheless, it tempered the view about how aggressive the Fed might be in coming weeks.
The war in Ukraine is still affecting global fixed income markets, primarily through its impact on the cost of energy. Attacks and alarums in Moldova worried investors, whilst both Russian and NATO officials stepped up the rhetoric. Inflation fears were not helped when Russia announced it was shutting off gas supplies to Poland and Bulgaria, causing an instant 20% spike in European wholesale gas prices. Oil prices rose above $104 per barrel on reports that the EU would halt imports of Russian crude after news that Germany has dropped its opposition to such a move.
Recent IMF and World Bank analysis suggests that the inflation situation globally is akin to a perfect storm. They warn that the Ukraine war’s impact could be longer-lasting than previous commodity shocks, partly as there is less room now to substitute across different energy sources, because production was tight after years of subdued investment, partly as high natural-gas prices raise fertilizer and hence food prices, and partly due to more costly patterns of trade.
This backdrop helps explain why markets still have a high degree of conviction about what will happen at the next few central bank meetings. The Bank of England will lift rates again on May 5th, a Reuters poll concluded. After all, a CBI survey warned that expected increases in sales prices remain at extreme levels. Similarly, the markets are fully priced for a move of 0.5% by the Federal Reserve at its next meeting, indeed possibly several 0.5% moves into the summer. In contrast, Christine Lagarde is still hinting that the first move by the ECB will not be until July. The central bank and EU governments are struggling to assess the full effect of the tsunami which Ukraine has created, in terms of its impact on energy supplies, defence budgets, refugee support, and regional trade.
The gap between interest rate expectations in different countries is flowing through currency and bond markets. For example, the euro has fallen to a five-year low against the US dollar while the pound is heading back towards lows last seen in 2020. More expensive import prices will just add to the pain being felt by many sectors.
Looking further ahead, central bankers and markets still await important information about the economic cycle. Will a wave of wage demands swamp the labour markets, will the wave of Covid infections in China die down quickly, does the collapse in consumer confidence mean households are starting to tighten their belts or is the more upbeat business sentiment data a better sign of future prospects? On the basis of the answers to those questions, then bond markets will assess whether central banks continue to push ahead this autumn with tighter policy to dampen inflation expectations even as economic growth slows.
Central banks around the world see a storm surge of inflation approaching. Will their defences be able to hold, or will floods break through?
Bond yields at the time of writing this week and one month change
% 2 year 5 year 10 year
USA 2.64 (+0.30) 2.88 (+0.40) 2.87 (+0.40)
UK 1.54 (+0.18) 1.63 (+0.22) 1.88 (+0.26)
Germany 0.20 (+0.32) 0.64 (+0.28) 0.90 (+0.32)
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