Interest rates up, bond yields down
Interest rates were increased another 0.25-0.5% by the major central banks this week, all of whom indicated that there was more to come. However, bond yields in the three major markets all fell by 0.15-0.2% over the week. Central banker speeches and statements were interpreted by investors as signaling interest rates could be cut by year end, unless there are some major economic or political surprises.
The Federal Reserve has moved away from 0.5% rate moves, only acting by 0.25% this week. The justification for such a move was nuanced to some investors, confusing to others. The Fed said it had turned the corner in its fight against inflation, but that victory would still require rates to go higher and stay elevated through at least 2023. On the plus side Fed Chair Jerome Powell said “we can now say for the first time that the disinflationary process has started”, yet he also warned that the Fed is going to be cautious about declaring victory as “the labour market continues to be out of balance”.
Economic data continues to support both sides of the debate. Employment costs for businesses are running about 5% year on year, well above the levels that the central bank would like to see. Powell has intimated that wage growth needs to slow by 1½-2%, which models would suggest needs a rather higher level of unemployment than currently being seen. Yet the Chicago Fed National Activity Index is still at levels signaling weak growth into the spring – not a recession. All in all, financial markets are more convinced that the peak in the Fed fund rate is within sight and – more importantly – expect that the Fed will begin a substantial easing cycle in the second half of the year.
The ECB also moved rates by 0.5%. However, the accompanying press conference was a little confusing for market participants. The easiest way of explaining this concerns the mixed state of economic data. Yes, headline inflation has fallen back from 9.2% to 8.5% a year, but the core rate was unchanged at 5.2%. Yes, the bank is well aware that growth was muted into year end. Indeed, European money supply figures are decelerating sharply, whilst a commercial bank lending survey showed tightening credit standards and lower demand for borrowing from both households and businesses. However, economic sentiment improved in January, with the service sector especially seeing better activity. Employment expectations are rising again, putting strain on an already tight labour market. Despite Germany being on the verge of a modest recession, its unemployment rate has dropped to 5.3%. There was strong guidance from the ECB for a 0.5% hike in March, and possibly another after that too, but forthcoming economic data and updated forecasts should heavily influence the ECB’s decision.
In the UK, the MPC also raised rates by 0.5%, no surprise in view of persistently high wage and service-sector price inflation. However, there are differences of view across the committee, as two members voted for no change. This will encourage market speculation in favour of a smaller 0.25% rate hike in March, and indeed that this could mark the top of this tightening cycle. After all, the Bank must be wary that the UK remains in recession in 2023, contrary to modest growth in other major economies. The IMF has updated its forecasts: global growth is expected to be 2.9% this year, led by China at 5.2%, the US at 1.4%, the Eurozone at 0.7%, but Britain faces the bleakest two years of any major industrial nation, with a recession in 2023 (GDP down 0.6%) and the slowest growth of peers in 2024. Such a backdrop helps explain why the Bank forecasts UK headline inflation to fall from about 10% at the start of this year to only 3% by year end.
Where next for all three central banks? Many analysts argue that bond markets face a fork in the road. Either central banks are correct, and rates will stay higher for longer than is priced into market expectations, or market expectations are correct and central bankers must back down from future rate increases and indeed start to cut rates soon.
All three central banks emphasized that they are dependent on new economic data. The state of the labour markets might still surprise, as could energy prices. Thirdly, the speed of recovery in the Chinese economy could upset investors. Its business surveys improved sharply in January, potentially leading to much stronger commodity prices. Last of all, negotiations about the US federal debt ceiling could also worry the markets. President Biden and House Speaker McCarthy met on Wednesday to discuss the situation, but political analysts would be highly surprised if negotiations came to a swift conclusion.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.01 3.47 3.38
UK 3.15 2.87 3.01
Germany 2.49 2.01 2.07
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