The UK starts to diverge from the USA and Europe
‘Higher interest rates for longer’ has become the underlying theme in bond markets, as investors and central bankers assess a stream of positive economic news and some worrying inflation evidence. However, there are signs that the UK may be closer to the end of this interest rate cycle than the USA or Europe.
Certainly, inflation needs careful monitoring in this country. The British Retail Consortium reported that shop price inflation accelerated to 8.4% a year, with food prices rising over 14%. More positively for the Bank of England, its own business survey found that firms expect to raise prices and wages less aggressively into the spring. Economists are still forecasting a modest UK recession in 2023, and there are clear pressures on household finances; the CBI said retail sales were flat in February after January’s fall, whilst the GfK consumer confidence measure is still at levels associated with recession. All in all, this data is seen as likely to support the MPC raising rates by 0.25% rate hike in March and then pausing to assess the situation.
Conversely, in the USA, economists are pushing back their timescales for when a recession might appear. Evidence grows that the US consumer started the year in good heart; on one measure, spending showed the strongest monthly gain since Congress handed out stimulus cheques during the pandemic. A tight labour market is supporting income growth, aided by cheaper petrol and continued credit growth. Estimates for first quarter GDP growth are shifting up towards 2-3% a year. This is happening whilst consumer expectations of future inflation are still closer to 3% than the Fed’s 2% target. Nevertheless, there is weakness in the economy, notably in housing but also in manufacturing. Narrowing corporate profit margins suggest firms are having difficulties passing through rising labour costs. This explains why the Federal Reserve has stepped down to 0.25% moves at each meeting whilst it assesses the data.
There were a few signs that activity in parts of Europe was not strong. Germany reported negative GDP growth in the 4th quarter of 2022. Monetarists at the Bundesbank will be pleased to see that Eurozone broad money supply growth slowed to only 4.5% a year. However, the ECB will be much more concerned about the strength of inflation; the headline rate only decreased from 8.6% to 8.5% in February with core inflation moving up to 5.6% year on year. This reflects rising service sector inflation led by wages growth. Against this backdrop the markets expect another 0.5% move by the ECB in March.
Moving away from Europe and the USA, it is important to emphasise that China’s business surveys were buoyant. The official manufacturing measure was the highest in more than a decade, whilst a services sector reported its highest levels since last August. This probably reflects the loosening of credit conditions and the U-turn on covid restrictions by the government, all part of the efforts to boost the 2023 growth rate in the world’s second largest economy. Such strength will affect the European and even US economies much more than the UK.
Reflecting this news, most central bank governors were hawkish rather than dovish in their statements. In the USA, although Raphael Bostic felt “slow and steady is going to be the appropriate course of action”, Loretta Mester argued “it’s going to take more effort on the part of the Fed to get inflation on that sustainable downward path to 2%” and Christopher Waller warned “if those data reports continue to come in too hot, the policy target range will have to be raised this year even more to ensure”.
Over in Europe, the minutes of the latest European Central Bank’s February meeting reflected a hawkish debate and a clear intention to continue hiking rates. Bundesbank President Joachim Nagel said core inflation remains too high and “will remain at very high levels beyond March and only decline slowly. That’s why I’m not ruling out that further interest rate hikes, significant interest rate hikes, beyond March, may be necessary”. Stopping tightening too early would be a “cardinal error”. Remarks from his colleague Pierre Wunsch explicitly put the 4.0% peak rate idea on the table.
The MPC’s Catherine Mann did worry that the slump in energy prices might prompt UK consumers to spend more on other things, potentially pushing up inflation in other parts of the economy. Andrew Bailey was interpreted in a more dovish manner though as the economy is performing more as he expected. “At this stage, I would caution against suggesting either that we are done with increasing Bank rate, or that we will inevitably need to do more,” he said. “Some further increase in Bank rate may turn out to be appropriate but nothing is decided. The incoming data will add to the overall picture of the economy and the outlook for inflation, and that will inform our policy decisions.”
Markets are reacting to this news by shifting expectations about the peaks in rates. US bond yields generally rose 0.25% in just a week. A peak interest rate of 5.5% is now almost fully priced in, whilst investors are also coming to terms with no Fed rate cuts in 2023. The 10 year Treasury yield has breached 4.0% so on its way to testing the peak of 4.25% last autumn. Even larger moves were seen in Europe, as market expectations shift towards the ECB moving its policy rate above 4% by the end of the year; only a few weeks ago the peak was seen about 3.5%. Such moves did drag gilt yields modestly higher, but a divergent economic backdrop is protecting the UK market for the time being.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.88 4.30 4.04
UK 3.86 3.67 3.88
Germany 3.23 2.85 2.75
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