A tug of war
This was another week when the news flow pulled bond markets first one way and then another. US benchmark bond yields have fallen to a 7 month low, but the next set of employment data just before the long Easter weekend could certainly spark a reversal.
Several items summed up this tug of war. Firstly, OPEC decided to cut production by about 1 million barrels per day, with the understandable effect of pushing the oil price back up towards $80 per barrel; some analysts warned of $100 ahead. Such moves quickly feed into inflation expectations and hence bond market pricing. Other data showed the mixed state of the economy. Manufacturing sector reports are generally weak globally, indeed one measure in the USA was its lowest since May 2020. Whilst households do not seem to be spending money on goods though, they certainly are on services. People want to experience holidays, bars and restaurants again. Hence service sector surveys remained in expansion mode across China, Europe and Japan and European, although the US figures were somewhat muted in comparison.
Economists still expect modest growth or even short recessions in many countries later in the year. Labour markets are slowly responding to last year’s monetary tightening. Unemployment rose more than expected in Germany in March, where the rate ticked up to 5.6%. One US survey showed that the number of openings per unemployed person has fallen from to 1.7 from 1.9. Such pessimism was supported by a report from the World Bank, which warned that the global economy faces some of the slowest rates of economic growth for 30 years.
Despite such news and trends, hawkish central bankers continue to express concerns that inflation is becoming embedded and will take too long to return to target. Certainly there is more evidence that headline inflation has peaked. For example, annual Eurozone consumer inflation has fallen to 6.9%, its lowest level for more than a year. However, the core rates of inflation excluding food and energy are still much higher than central banks would like to see. For example, a measure of US personal consumer expenditure inflation is running about 5% a year, whilst European core CPI inflation is running at 6.7%.
This explains why the likes of Loretta Mester said the Federal Reserve likely has more interest rate rises ahead amid signs that the banking crisis has been contained. To keep inflation on a sustained path down to 2%, she sees monetary policy moving “somewhat further into restrictive territory this year, with the fed funds rate moving above 5% and the real fed funds rate staying in positive territory for some time”. Mester also pushed back on market views that the Fed will need to cut rates, saying “Can I come up with scenarios that would have the Fed cutting rates? Yes. Is it my model forecast? No”. For the ECB, Luis de Guindos also argued that it looks likely that price pressures will remain elevated.
The UK economy is not as strong though as its European or US counterparts. Harvir Dhillon, an economist at the British Retail Consortium, explained that whilst there has been a bit of an uptick in consumer confidence “There’s still some anguish about the wider economic context. Despite the potentiality that we will avoid a technical recession, there is the inescapable reality that for many, it does feel like a recession. There’s a big chunk of the consumer basket that’s still seeing price increases, month on month. So it’s clearly having a dampening effect on how consumers are feeling.”
Nevertheless, Bank of England speeches showed a debate still taking place. Chief economist Huw Pill indicated he would support a further move in May, speaking of the need to “see the job through” when it comes to inflation, arguing that “on balance the onus remains on ensuring enough monetary tightening is delivered”. Conversely, Silvana Tenreyro suggested that the current level of interest rates would require an “earlier and faster reversal” than has been posited in order to “avoid a significant inflation undershoot”. She voted not to change the current position at the latest meeting, arguing that the rate has moved into “restrictive territory”.
Although news about the banking sector has died down, and there were signs that access to the Fed’s emergency support has pulled back, this does not mean the problems are over. An ECB report warned about the major dangers facing real estate as access to credit declines. According to Bloomberg Intelligence, almost a quarter of European bank profits could be wiped out if there is a 5% write down in the value of commercial real estate loans. JP Morgan CEO Jamie Dimon warned that “The current crisis is not yet over, and even when it is behind us, there will be repercussions from it for years to come”. After all, on some estimates the rise in interest rates and bond yields has caused losses amounting to $2 trillion in bond holdings across the whole financial system.
The surge in interest rates and bond yields over the past year will percolate through other aspects of economies for years to come. Articles are being written about defined benefit pension schemes; as these come back into surplus they will increasingly be transferred from corporate sponsors to insurance firms to look after. The Financial Times saw “profound implications for fixed income market structure, government financing, the transmission of monetary policy, as well as aspirations from within government, the City, and beyond that our vast pension assets be deployed in a manner that funds growth and innovation”.
In a tug of war, the teams can move back and forth. Bond markets remain volatile. On the day that some weak US labour force data appeared, investors moved the probability of a rate hike in May down from 65% to 47%, and priced in rates falling by 0.8% rather than 0.6% by year end. This tug of war between data and commentary looks to continue for some time.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 3.73 3.32 3.28
UK 3.33 3.25 3.42
Germany 2.49 2.14 2.15
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