Don’t expect any surprises from central bankers at Christmas
Bond markets were relatively calm before the wave of policy announcements taking place next week, after which markets will shut down for the festive period. On balance, the MPC, Federal Reserve and ECB are all expected to raise interest rates by another 0.5% in December. Some statistics and policy announcements suggested that the approaching slowdown in activity will not be quite as pronounced as previously expected, adding to a small but notable rise in bond yields in the UK and most of its major counterparts.
It is clear what is priced into the markets: a terminal or peak level of interest rates of about 5% in the USA, about 4.5-4.75% in the UK and around 3% for EMU members. However, the risks are also clear: if labour markets do not ease, if headline inflation worsens again, if pay awards feed through into core inflation and inflation expectations, if fiscal policy is too supportive, then policy makers will act. It is not easy to assess quite how tight current policy is, when interest rates and quantitative easing bond buying programmes overlap so much. At least one measure, the Chicago Fed’s National Financial Conditions Index, it looks as if the Fed has yet to exit an accommodative monetary posture.
Yes, there is a slowdown in the world economy. Consumers are buying fewer cars, homes and durable goods. November’s global manufacturing PMI surveys continued the theme of a steady deceleration, without any obvious signs of a sudden deterioration. However, two events added to the view that central banks may have more work to do rather than less.
The first was the volte face being seen in China. After the wave of protests, the Chinese government has begun to relax the covid restrictions rather faster than expected. There has been speculation that a growth target of 5% might be announced for next year. Commodity markets have shown some strength as a result.
The second piece of news was the services sector ISM survey for the US economy. Contrary to other indicators it suggested an expansion, rather than a slowdown, in this particularly important segment. Hawks in the Fed will also worry about current levels of core inflation, currently running about 5.5-6.0% year on year depending on which measure is used. This might slow rather slowly. The Atlanta Fed wage growth tracker is showing median wage growth around 6.5% year on year. Some economists warn that levels of wage expectations currently becoming embedded mean that inflation will settle down to an underlying trend rate of 3.5-4.0%, about double central bank targets.
There was little UK specific data this week. Consumer spending appears to be muted in the run up to Christmas, and inflation does seem to be rolling over. The BRC retail sales monitor indicated volume growth considerably restrained by higher shop prices. None of that is no great surprise to the Bank, however, and the pace of economic deceleration into 2023 remains rather uncertain. Steady as she goes then, and assess the situation in much more detail at the February Inflation Report and MPC meeting.
There were a few ECB speakers, none of whom indicated any need for the bank to take a much softer tone. French central bank governor Francois Villeroy de Galhau said the central bank should raise rates by 0.5% at its next meeting, but only expects inflation to be beaten around 2024/25. Vice President Luis de Guindos warned that headline inflation in the middle of next year inflation might still be over 7%. Chief economist Philip Lane agreed that 0.5% was more likely, as “We should take into account the scale of what we have already done”, but “Given the significant increase in energy prices, I don’t rule out some extra inflation early next year” whilst “The journey of inflation from the current very high levels back to 2% will take time”.
Bond markets are unlikely to be surprised by the Christmas presents which they receive from central banks next week – it would be a surprise if rates do not alter by 0.5%. As ever the forward-looking statements from Bailey, Lagarde and Powell will be interpreted carefully by traders. However, as this week has shown, new news on the robustness of activity in major economies into 2023 would force central bankers to take rates higher or leave them higher for longer.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.28 3.69 3.47
UK 3.34 3.22 3.12
Germany 2.08 1.86 1.85
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