Lots of movement but little change in markets
Bond and equity markets have witnessed considerable volatility in the past week. On one day, for example, the yield on 2 year UK gilts fell by 0.23% with 10 year yields down 0.14%. In technical terms, the MOVE or Merrill Lynch Option Volatility Estimate index, which measures bond market volatility, recently rose to its second-highest level since 2009.
Why did this happen? One reason has been rather poor trading liquidity. A mix of volatile political news, weaker economic data yet rapidly tightening monetary policy, has all made traders and market makers less willing to take risk. One outcome is that asset prices move in buying or selling bursts.
There were also some useful reports suggesting that economic activity was weakening into the autumn, meaning that central banks will not have quite so much work to do. The US Treasury market paid attention to a major manufacturing survey showed stalling growth in factory activity, alongside a sharp decline in new job openings. The American data matched that from a number of surveys from other Asian and European countries reporting slower growth. JP Morgan estimate that global manufacturing activity has fallen to its lowest since June 2020.
At the same time, a public backlash against ever higher interest rates is growing, not just from politicians. Failing to halt soon would risk a global recession followed by prolonged stagnation, warned the U.N. Conference on Trade and Development. It estimated that a percentage point rise in the Fed’s key interest rate lowers economic output by 0.5% in other rich countries and 0.8% in poor countries over the subsequent three years.
Conversely, other factors pushed for higher bond yields this week. Consumer inflation expectations had come down in September, helped by lower petrol and gasoline prices. Bond investors did not like the decision then by OPEC to cut output, which spurred oil prices to back up. Another factor supporting bond yields was the continued flow of hawkish commentary, especially ahead of the next Federal Reserve meeting in early November. Hence, Fed Vice Chair Lael Brainard said that “monetary policy will need to be restrictive for some time to have confidence that inflation is moving back to target. San Francisco Fed President Mary Daly said the “path has been very clear: we are going to raise the rate until we get into restrictive territory, and then we are going to hold it there”. New York Fed President John Williams concluded that “Tighter monetary policy has begun to cool demand and reduce inflationary pressures, but our job is not yet done”. The ECB has also been hawkish, by its standards. ECB president Christine Lagarde said “we will do what we have to do, which is to continue hiking interest rates in the next several meetings”. Bank of France Governor Francois Villeroy de Galhau said. “We will raise interest rates as much as necessary to bring core inflation down”.
However, the tensions between tighter monetary and easier fiscal policy continue to grow. A few days ago, the German government unveiled a massive €200bn borrowing plan to create a “protective energy shield” for its households and businesses. Other countries may follow suit, for example the new Italian government is understandably concerned that the economy is entering recession. The ECB will also be wary that Italian bond yields have reached 4.5%, meaning the gap or spread over German bunds has widened to 2.4%
Immediate concerns about the state of the UK’s financial markets have died down, helped by Bank of England gilt purchases and the Chancellor’s U-turn decision not to abolish the 45p tax band. This helped lower the expected peak in UK interest rates towards 5.5% rather than 6%. Nevertheless, the government faces significant hurdles in coming weeks. Ratings agencies have voiced their concerns, with S&P putting the UK’s credit rating on a “negative outlook” whilst Fitch lowered the credit rating from stable to negative (still AA-). Despite the expansionary fiscal package, S&P now expects the UK’s GDP to contract by 0.5% in 2023, rather than its previous forecast of growth up 1%. One reason is that there has in effect already been a significant monetary tightening in the UK – mortgage rates are closer to 6% for many new products. The OBR’s approaching assessment about the medium term growth, spending, tax and borrowing outlook remains of great significance.
All in all, any calm in headline bond yields should not disguise a wide range of factors pointing towards rather higher or lower yields. Fiscal vs monetary policy, growth vs inflation trends, politics and climate change, all are pulling in different directions.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.21 4.05 3.83
UK 4.15 4.42 4.26
Germany 1.78 1.95 2.09
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