Munix Weekly 29 July
“Tomorrow matters more than today”
Fixed income markets involve considerable jargon, such as duration, spread and basis points. An important phrase is inversion, the situation when the yield on long dated bonds is less than the yield on short dated debt, contrary to the usual experience of an upward sloping yield curve. At the very least such a situation suggests weak economic growth ahead, or potentially even recession – although these are not normal times when central bankers are manipulating financial markets so much.
The US Federal Reserve was widely expected to raise interest rates by another 0.75% this week, and duly complied. As ever, the comments from Chair Jerome Powell had more of an impact, hinting that future rate moves would be more gradual as long as the economic data was supportive. In particular, he acknowledged the long and variable lags between policy decisions and the real world impact. After interest rates have risen by 2.25% in 5 months, by far the fastest pace in 40 years, markets are indicating only another 1.25% on rates by year end. Indeed, the futures markets are pricing in the likelihood that the Federal Reserve will actually cut rates by next summer to bolster growth. Such thinking helped the US 2 and 10 year bond yields end the week well below 3%.
Such a view is partially explained by report after report demonstrating weaker economic data. The US has officially entered a very modest recession, with GDP falling marginally in Q1 and Q2, whilst the latest business surveys indicate poor activity into the third quarter. This helps the argument amongst bond investors that the Fed will get on top of inflation, helped of course by lower commodity prices. A key gauge of investors’ inflation expectations, known as the five-year, five-year forward breakeven rate, has fallen to about 2%, the lowest level since early 2021, close to the central bank’s official target.
Similar declines in bond yields have been seen across Europe, indeed the German benchmark is at a three month low. This week’s European data was rather downbeat, such as the Ifo business survey, and that was before the latest news about Russia turning the screws once again in terms of limiting its gas exports to EU members. Markets are still of the view that the ECB will raise interest rates by 0.25-0.5% at its next meeting, after all German inflation in the year to July has edged up again to 8.5%, but the inflation cycle is expected to roll over. This was the week when the IMF downgraded its forecasts for global economic growth in 2022 and 2023, with particular warnings about the array of headwinds facing the EU, and the UK.
The Bank of England has initiated a period of radio silence before its next policy meeting on 4th August. Governor Andrew Bailey has said that “a 50 basis point increase will be among the choices on the table when we next meet”, and certainly some analysts think that the Bank will do that much in order to contain inflationary pressures. The wave of strikes for higher pay will worry MPC members even though there is evidence from, for example retail sales, that household budgets are under pressure, and many economists warn of a modest UK recession into the winter. The key question is where are interest rates at year end? Markets have steadily pared back expectations for ‘peak’ base rate from 3.5% to 2.9%. The risk is that such views could change quickly after the appointment of a new Prime Minister with a mandate to cut or increase taxes significantly. Benchmark gilt yields have followed their counterparts in other countries, now back well below 2%.
An inverted yield curve is traditionally seen as an indicator of weaker economic activity tomorrow than today, enabling central banks to ease monetary policy. The question bond investors face is not whether a recession appears but how deep and long, or short and shallow, it might appear. At a time when supply and demand are so out of balance in many economies, also important will be the length of time it takes for monetary policy and economic adjustments to bring about some form of equilibrium, and how high inflation will go, or economic activity will slide, during that process.
Bond yields at the time of writing this week
% 2 year 5 year 10 year
USA 2.88 2.69 2.66
UK 1.72 1.61 1.88
Germany 0.24 0.52 0.81
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