Are we nearly there yet?
Many a parent will be familiar with the plaintive cry from children in the back of the car: “are we nearly there yet”? Financial markets are feeling much the same. Central banks are steadily taking interest rates higher, but perhaps the end is in sight, as long as unexpected events do not interrupt the journey. In the jargon of the market places, when will central bankers pivot away from ever tighter policy?
The closest to a pivot – or at least reaching peak interest rates – would appear to be the Bank of England. Of course, it faces the situation that household incomes and company profits are already under serious pressure from the rise in energy prices and other costs. The Chancellor is also threatening a series of tax hikes and spending cuts at the Autumn Statement later this month. Rumours are circulating in the media of extensions to windfall taxes to raise about £40 billion over the next few years.
Some members of the Monetary Policy Committee had already indicated that they thought the markets were pricing in too much action. Shortly before the Bank went into its customary purdah period before the MPC meeting, Catherine Mann, one of the more hawkish committee members, said that markets are “too aggressively priced”. Deputy governor Ben Broadbent suggested that GDP would take a sizeable hit if the Bank were to deliver that sort of tightening.
The announcement of interest rates rising by 0.75% was fully expected by the markets. Economic forecasts made by the Bank hinted at smaller increases ahead. Firstly, it warned that the UK is already in a shallow but long recession due to last until mid-2024. Secondly, its projections showed that, if policymakers were to follow investor expectations and hike rates to 5%, the size of the economy would shrink by roughly 3 percentage points over several quarters. Inflation would be at zero in 2025. Against such a backdrop, it was not great surprise that one policymaker, Silvana Tenreyro, voted for just 0.25% of tightening. Hence, many economists now expect only a 0.5% hike in December, plus modest moves in the spring, so the peak is likely to be closer to 4% than 5% or even 6% considered as possible just a few weeks ago.
The Federal Reserve is not yet close to pivoting. Although the rise in interest rates this week (0.75%) was much as expected, the tone and tenor of the subsequent statements from Chair Jerome Powell at the press conference shaped expectations for December and beyond. He seems to have planted the seed for a move of only 0.5% next month; economists are talking about a similar move in the first quarter of 2023. A slowing pace of hiking is justified to give the economy a chance to demonstrate that it is slowing and hopefully for inflation pressures to respond to all the policy rate moves.
However, Powell’s statements also indicated that the Fed would probably take rates to a higher level and leave them there for longer than the market had expected. The money markets are back to pricing in a peak of interest rates around 5.25% in spring next year. This made sense in the light of the Chair’s comments that, regardless of how fast the Fed moves, “there’s some ground to cover” for the target interest rate to reach a “sufficiently restrictive” level that will slow inflation, that “cumulative tightening” matters more than individual rate increase, so that it was “very premature” to discuss when the Fed might pause its increases. The Fed also said it will continue to shrink its balance sheet, that is selling bonds into the market place.
Such an outcome makes sense. Inflation expectations priced into government bond markets remain too high, closer to 2.5% than the 2% target. Neither headline nor core inflation are yet trending down sharply. Only parts of the labour market are showing signs of cooling, although the next few employment reports will be watched with considerable interest. The next Fed meeting will see a useful update to its forecasts, and the various “dot” projections from each Governor.
US bond yields moved higher over the week on such news, and European yields followed suit. Despite the news that the European manufacturing sector appears to be entering into a recession in the autumn, other EU GDP data indicated that the overall economy held up quite well last quarter. On top of this, the Euro area CPI for October jumped again to 10.7% year on year with the core rate still at 5%. Such data will be ammunition for the hawks to show that there is no need yet to pivot to an easier policy. In contrast to such moves, UK yields did move lower during the week. The premium for gilts over bunds is still about 1.25%, rather than the usual 1%, but it is declining. More dovish speeches from the Bank alongside firm action by the Chancellor on November 17th would help investors decide that the end is in sight at least for UK markets.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.68 4.35 4.13
UK 3.01 3.39 3.49
Germany 2.05 2.12 2.23
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