Munix Weekly 5 May 2022
The convoy is moving at different speeds
Anyone who reads the regular analysis produced by the Bank of England will know that the domestic influences on monetary policy are definitely set in the context of the wider international scene. Indeed, it is often best to see the UK as positioned in a long convoy of ships, currently led by the USA, followed by advanced economies such as Australia, the UK in the middle, then Europe with Asia lagging behind.
The key news this week was the 10-year US Treasury yield reached 3%, the highest level since November 2018. On balance inflation warnings were considered more important than central bank decisions. It was no surprise that the Federal Reserve raised interest rates by 0.5%, the first hike of this size since May 2000. Neither was it a surprise to learn that the central bank will soon start to reduce its sizeable holdings of government bonds. There was awarm glow from the news that not only did the Fed did not raise rates by 0.75% at its meeting, nor is such a move considered likely over the summer. This led to a noticeable fall back in short–dated bond yields, soon turned around by a report demonstrating the embedded inflationary pressures in the economy. Unit labour costs for businesses increased 7.2% from a year ago, the largest gain since 1982, as hourly compensation increased 6.5% whilst productivity dropped with the slowing economy. Fed Governors have not yet seen the official labour market report for April, but surveys suggest the strongest demand for workers since 2005.
Such news helps explain why the market still expects 0.5% moves at the next two Fed meetings. Economists are actively debating whether a soft landing will eventually appear (the last one was back in 1994) or a recession will result (three quarters of hiking campaigns end in one). Preventing an incipient wage-price spiral will have to come from deliberate policy to slow the economy
Markets had fully expected that the Bank of England would raise interest rates by 0.25% to 1%. The rest of the statement was a surprise. To quote one City economist “‘the composition of votes and the large forecast changes have given investors a lot to digest”. In particular, a minority of Committee members called for a bolder hike of 0.5%. This is partially explainedby the Bank’s forecast that headline inflation could reach 10% before year end. As just one example, the British Retail Consortium is warning about sharp rises across all shop prices. Accordingly, markets expect UK rates to reach 2.0-2.25% by year end.
Such moves and significant tax increases will affect the economy – the Bank envisages that there will only modest growth and occasional quarters of weakness in the coming year. Another trade off facing the Bank is that higher interest rates might also mean further cuts in public spending or tax increases. The MPC will be aware that a 1 per cent rise in both interest rates and inflation eventually adds £20 billion to service the UK’s public sector debt. Debt servicing costs for the latest financial year reached a record high of nearly £70 billion. This might explain why the Bank is still at the planning stage in terms of actively selling bonds in its portfolio.
Looking further along the convoy, the Reserve Bank of Australia raised rates for the first time in a decade, whilst its Governor talked openly of the need to raise rates eventually towards 2.5%. The Reserve Bank of India also raised rates unexpectedly above 4% in an unscheduled move. India’s mega heatwave is also exacerbating inflationary pressures.
The ECB is steaming gently behind the others, with the eventual peak in rates only expected to be about 1.75%. Whilst there were aggressive comments from some governors – Isabel Schnabel talked about a rate rise as soon as July – others were more concerned about the prospects for a modest recession over the summer – a large recession would result of course if Russia stopped gas exports. ECB Executive Board Member Fabio Panetta was quoted as saying “the European economy is de facto stagnating”. Nevertheless, investors priced in further action; Germany’s 10-year government bond yield, the benchmark for the eurozone’s debt markets, climbed above 1% for the first time since 2015.
Other central banks face a dilemma. The widening interest rate gap between the USA and Japan, for example, has led the Japanese currency to fall to its lowest level since 2002. The Bank of Japan would prefer not to be aggressive, however, when inflation is broadly zero, and government debt is so large.
It is always helpful if the central bank convoy has a lighthouse or two to help steer the course. Every policy maker is data dependent amidst greater than normal uncertainty. Every central bank is running an experiment – how much in the way of short rate hikes can the private sector absorb without undue damage. Full steam ahead or time to change course?
Bond yields at the time of writing this week and one month change
% 2 year 5 year 10 year
USA 2.70 (+0.18) 3.00 (+0.30) 3.03(+0.49)
UK 1.504 (+0.4) 1.63 (+0.14) 1.92 (+0.25)
Germany 0.25 (+0.28) 0.72 (+0.28) 1.00 (+0.39)
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