Weekly Update 31st March 2023 – by Andrew Milligan

The storm has ended, for the time being

 

As the banking crisis has died down, at least for the time being, investors have started to reassess the situation. After examining a range of economic data and further signals from central bankers, the outlook for interest rates has evolved. The result was a noticeable 0.25% move upwards in bond yields in most countries over the past week.

 

There are more signs that large parts of the world economy are prospering at the end of the first quarter. The combination of lower energy prices, higher wages, and considerable fiscal support have offset tighter monetary policy. True, there are areas of weakness. Business surveys in the USA, China, the EU, Japan and the UK all showed further pressure on manufacturing (the PMI or ISM surveys were generally in a range of 45-50, signalling contraction rather than expansion). This was reinforced by the US durables goods report describing a loss in momentum in capital investment orders. Elsewhere, housing markets remain under pressure, whilst provisional data suggests that German retail sales fell at a stunning annualised of more than 11% during the past 3 months.

 

However, such weakness was more than compensated for by the strength of the much larger and more important services sectors in all these economies. There were special factors, hence activity in China was boosted by the ending of Covid restrictions. Nevertheless, most ISM/PMI business survey reports were in the 50-56 range, showing strong expansion. Europe was particularly strong; the German Ifo business survey improved for a 6^th month, with similar expansion across its French and Italian counterparts.

 

UK business surveys showed comparable trends, whilst retail sales were better than expected in February, growing 2-3% a year, although details such as more spending at discount stores shows the cost of living crisis facing many households. The Bank of England cannot have been pleased, though, at seeing the British Retail Consortium report prices continued to climb by 9% a year in March, primarily led by food.

 

There is a dilemma in interpreting all this data. A Bloomberg survey showed economists have been upgrading their forecasts for economic growth this year, for example towards 1% for the USA. Yes, the shape of the yield curve still suggests a recession ahead but any downturn is expected to be limited to the third quarter. The counterpart is continued pressure on prices. The Bloomberg survey found economists raising their forecasts for core US inflation this year to 4%. Similarly, a stream of European inflation reports for March indicated that the headline rate might come down to about 7%, helped by much lower gas prices, but core Eurozone inflation was likely to remain at the heady heights of 5.5%.

 

Such inflation pressure certainly inform thinking at the ECB and Federal Reserve. Bundesbank President Joachim Nagel remains hawkish. “Wage developments are likely to prolong the prevailing period of high inflation rates”. “In other words, inflation will become more persistent”. “It will be necessary to raise policy rates to sufficiently restrictive levels in order to bring inflation back down to 2% in a timely manner”. His views were matched by colleagues. ECB Chief Economist Philip Lane explained that “Under our baseline scenario, in order to make sure inflation comes down to 2%, more hikes will be needed”. “If the financial stress we see is non-zero, but turns out to be still very limited, interest rates will still need to go up”. Schnabel and Kazmir also said further rate hikes will be needed, albeit at a slower pace. Such comments affected market rate expectations in the eurozone, drifting towards 0.5% of further tightening by September.

 

The debate was more nuanced in the USA. Jerome Powell indicated just one more rate hike before pausing to assess. Neel Kashkari, who in recent months was a proponent of rate hikes, worried that recent developments in the financial system would bring the US closer to recession. “What’s unclear for us is how much of these banking stresses are leading to a widespread credit crunch …. that would then slow down the economy. On the positive side deposit outflows seem to have slowed down. Some confidence is being restored among smaller and regional banks. At the same time … we’ve seen that capital markets have largely been closed for the past two weeks. If those capital markets remain closed because borrowers and lenders remain nervous, then that would tell me, okay, this is probably going to have a bigger impact on the economy”.

 

Others at the Fed were less concerned and kept the door open to more rate rises. “Inflation remains too high, and recent indicators reinforce my view that there is more work to do to bring inflation down to the 2% target associated with price stability”, Susan Collins said, although banks are likely to pull back on offering credit, which will weigh on activity. “These developments may partially offset the need for additional rate increases”. Thomas Barkin emphasised the need to monitor the data. “I’m comfortable with the trajectory we are on now – meeting by meeting”. On balance, the money markets have decided the Fed will move again in May.

 

Such concerns were evident in the UK as well. When Andrew Bailey appeared before the Treasury Select Committee he showed his concern about the speed with which the banking crisis had erupted: “We are in a period of very heightened, frankly, tension and alertness.” Separately,

Catherine Mann explained why said she voted for a rate increase of 0.25%, rather than a bigger move, because she saw signs that inflation expectations were falling. A survey of businesses by the Bank showed firms expected inflation to be 5.6% in a year’s time, down from 6.2% in the assessment made three months earlier. “A key factor for me in agreeing with and also voting (with) the majority for a 25 basis point increase was that these forward looking measures of price expectations had started to moderate, which is exactly the signal to me that my monetary policy is having an effect”.

 

Investors have a busy few months ahead. On top of the usual stream of economic reports and central bank speeches, banking data will be examined closely. Obvious candidates include: weekly lending data aggregated by the Federal Reserve; profits reports by the banks from mid-April, with a focus on provisions for bad debts; the senior lending officers’ surveys, generally available in late April; in the UK the Bank will pay attention to its survey by regional agents for hard evidence on what is happening to businesses; in Europe the ECB will mull the details of the money supply figures. However, even if the banking crisis is coming to an end, another issue looms on the horizon – negotiations about the ceiling on issuing US debt. Economist projections of government cash flows suggest the Treasury bank account will hit empty during July.

 

Turning back to the big picture, the situation was well summed up by the head of the IMF Kristalina Georgieva: “The rapid transition from a prolonged period of low interest rates to much higher rates necessary to fight inflation inevitably generates stresses and vulnerabilities, as we have seen in recent developments in the banking sector.” How much stress will be seen in coming weeks.

 

Bond yields at the time of writing

%                                 2 year                           5 year                           10 year

USA                              4.11                             3.68                             3.56

UK                                3.44                             3.35                             3.50

Germany                      2.73                             2.38                             2.38

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.