The summit is in sight, but does a plateau or a valley lie ahead?
Many a tired mountain climber has cheered up, when they discern the summit approaching at the end of a long climb. However, rather than a valley on the other side, it may be more of a rugged plateau which looms out of the mists. Yes, there is a growing view amongst bond investors that the end is in sight to interest rate increases in the first half of 2023. However, whilst many traders are talking about rate cuts later next year, most central bank governors are warning of a lengthy period of high rates to bear down on inflation pressures.
Economists continue to be gloomy about the outlook for the global economy. There are areas of uncertainty, notably in the past week mixed signals from the Chinese government about opening up or closing down the economy in the face of unprecedented public protests about Covid restrictions. It is no great surprise that Nomura, for example, has forecast that China’s GDP will only expand by 2.4% this year, about half the traditional growth rate. Elsewhere, however, the Federal Reserve’s regional surveys and European business indicators all generally signal below trend growth or a modest contraction; indeed it is widely expected that the EU will enter recession this winter. Global GDP growth is expected to slow to 1.2% next year according to the Institute of International Finance, the weakest since 2009. Inverted bond market yield curves in the USA and parts of Europe are a classic signal of recession ahead.
If that is the case, shouldn’t central banks be closer to ending their programme of rate hikes and considering how, where and when they might start to relax monetary policy. The market consensus is that the MPC, the ECB and the Fed will all raise rates by 0.5% in December, and the same again in during spring of 2023. The debate is wide open, however, about what happens after that.
MPC speeches were relatively thin on the ground this week. There was some evidence of the differences of views within the Bank of England about the future path for inflation. Huw Pill expects it to start moderating next year, while Catherine Mann said inflation exceptions are becoming “increasingly embedded” in the prices companies charge and are drifting toward double the 2% target level.
Elsewhere, more central bankers warned of risks ahead. Minutes of the latest ECB meeting expressed fears that inflation may be getting entrenched amidst second round effects from a wage-price spiral. Some policymakers expressed the view that “monetary tightening would probably need to continue after the policy stance had moved into broadly neutral territory”. In subsequent speeches, Isabel Schnabel worried that government policies to cushion households and businesses from soaring energy prices would keep eurozone inflation higher for longer. Joachim Nagel was unclear when prices would drop back and felt monetary policy must ensure high inflation goes away as soon as possible. This week’s data that headline inflation rose 10% and core inflation 5% from a year ago would justify such views. The only good news was that Gabriel Makhlouf felt that “when we get into next year, the likelihood is that if the rates go up, they’ll go up by smaller increments”.
A major speech from Fed Chair Jerome Powell was interpreted as signalling fewer rate rises ahead – this quickly rippled through into benchmark bond yields down by about 0.25%. However, the economic data and speeches from other Fed governors suggest a rather more nuanced outlook. November’s employment report suggested the labour market has not yet responded to previous monetary tightening; solid jobs demand kept wages growing over 5% from a year earlier. Not only is Powell only one voting member, but he does not determine the views of others. New York Fed President John Williams argued that “I do think we’re going to need to keep restrictive policy in place for some time… I see a point probably in 2024 that we’ll start bringing down nominal interest rates because inflation is coming down”. Barkin similarly tried to quell speculation the central bank would reverse course relatively quickly next year. “I’m very supportive of the path that is slower, probably longer and potentially higher”. Other views included Loretta Mester stating that the Fed was nowhere near a pause in its rate-hike campaign, Lael Brainard arguing that the Fed needed to lean against the risk of inflation expectations becoming unanchored, whilst James Bullard repeated his call for additional interest rate hikes as “the policy rate has not yet reached a level that could be considered sufficiently restrictive”.
Bank of England decision makers need to balance external factors – a weak global economy, continued central bank tightening – with domestic factors too. A particular problem for the MPC is trying to assess the true state of the labour market. Strikes and shortages are signs of a noticeable imbalance between demand and supply. Recent days have seen news of unprecedented net immigration, set beside high levels of early retirement on grounds of ill health. The Office for Budget Responsibility has warned that the share of working age population on disability benefits is on course to rise from around 10% to almost 14% by 2027-28. On current trends, the UK will soon be the only country in the OECD where the workforce remains smaller than it was before the pandemic.
The past six months have seen the most rapid tightening of western monetary policy in more than 30 years. Financial markets see US rates peaking about 5.0% next year, UK rates about 4.75% and euro area rates about 3.0%. Many indicators suggest that this year’s rampant inflation has peaked yet there are many signs that wage inflation could remain sticky for some time to come. Hence, central bankers continue to warn that they will be very cautious about easing policy too quickly. There may be time to rest at the summit, but it could still be a long trek ahead.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.20 3.66 3.52
UK 3.22 3.17 3.07
Germany 1.97 1.75 1.77
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