MUNIX WEEKLY 8 April
The Observer book of birds can be useful
It is common place in the financial fraternity to pigeon hole policy makers into ‘hawks’ and ‘doves’, those who see inflation in every statistic and those who argue that ‘this time it is different’. The Bundesbank has a reputation as a generally hawkish institution, the Bank of Japan rather less so.
There is method in this madness. As and when a central bank governor makes a speech, it is worthwhile to assess: are they taking their usual line or is there a change in their stance? It was little surprise this week, for example, that ECB Chief Economist Lane suggested inflation will level off this summer and decline in the second half of the year. As long as oil prices remain around current levels of $100-130 per barrel, then such a forecast is likely to be correct.
It was much more interesting, however, when Lael Brainard at the US Fed signalled that she was in favour of a rapid decline in the Fed’s balance sheet, perhaps starting as soon as May. Seen as a dovish policy maker, such a statement added to perceptions that the Fed is becoming more aggressive. This was reinforced by the latest set of Fed minutes, building on the recent labour market reports. Details of the Fed discussion confirmed it is on course to halt the reinvestment of maturing debt and eventually to sell bonds outright. The door was also left wide open for 0.5% rate increases. The labour market is robust, with employment returning to pre-pandemic levels whilst wages are increasing at 5-6% a year. With no signs of a strong surge in productivity, and plenty of evidence of willingness to raise prices at a company level, the Fed will respond.
Analysts are swinging behind the view that US interest rates will rise by 0.5% at the next Fed meeting in May and possibly June as well. Markets suggest that the terminal interest rate in late 2023 could be around 3% versus 0.5% today. The entire yield curve has shifted up by close to 1% in the past month. A short period of yield curve inversion has faded as longer dated bonds have sold off. Higher real bond yields undermined equities, whilst the dollar has appreciated towards 2 year highs. Mortgage rates are reaching 5% which is undermining the housing market.
The debate between hawks and doves is ongoing at the ECB. Whilst chief economist Lane was sanguine about inflation prospects, Klaas Knot warned this week that “High inflation is not only a story of supply shocks. Aggregate demand has recovered far quicker than expected”, cautioning that household inflation expectations could de-anchor. Pierre Wunsch said “Based on the current outlook, so with positive economic growth, we will raise interest rates to zero by the end of the year. It’s actually a no brainer for me”. He also saw rates peaking at 1.5% or 2%, above the 1% anticipated by markets. European bond markets are responding, for example German benchmark yields are at their highest since 2018.
Gilt yields are being dragged up by this international backdrop. Nevertheless, the Monetary Policy Committee can be positioned into the more dovish camp. After all, gilt yields have only risen about 0.15-0.30% in the past month, half that seen in Europe and well below 0.8-0.9% shifts in America. Yes, there are warning signs about future inflation. A combination of soaring staff costs, energy bills and raw material prices has coaxed UK services firms into hiking prices at the fastest pace since records began in 1996, according to the latest purchasing managers survey. Nevertheless, the doves downplay the risks. Deputy Governor Jon Cunliffe, who was the only policymaker to vote against last month’s rate hike, stated “I do not think we are yet seeing a psychology of persistently higher inflation emerge. I am not at present convinced that we will inevitably have to lean heavily and constantly against an embedding of inflationary psychology. The risk is that you actually wind up with monetary policy that bears down on the economy”. Such views can be justified when considering the sizeable pressures on UK household and business finances from the record tax burden which appears this year. This is a very different stance to the easier fiscal policy seen in Europe, such as generous energy subsidies, or America, with Biden’s infrastructure programme in the run up to the mid-term elections in November.
A clear uptrend in bond yields is under way. Financial markets have accepted the fact that central banks are normalising monetary policy to try and dampen inflation expectations. The debate between doves and hawks will continue whilst central banks consider if more or less tightening is required to bring domestically driven inflation back under control.
Bond yields at the time of writing this week and one month change
% 2 year 5 year 10 year
USA 2.51 (+0.90) 2.72 (+0.66) 2.66 (+0.82)
UK 1.47 (+0.14) 1.52 (+0.28) 1.73 (+0.28)
Germany 0.0 (+0.58) 0.48 (+0.66) 0.68 (+0.55)
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