Passing the baton along in the relay race
All eyes have been on the USA in recent weeks, with the Jackson Hole conference of central bankers in Wyoming. This week the focus of attention swung across the Atlantic with the baton in the relay race passed to European policy makers. What would the ECB do? How would the Bank of England explain its thinking on the state of the world?
There had been copious comments and speeches from ECB Governors in recent weeks, strongly hinting that they would be forceful in their decision making. After all, headline inflation in many EU member states was at 40 or even 50 year highs, whilst the core rate of inflation was well over 4% versus the official under 2% target. The depreciation of the Euro versus the Dollar was also a concern to many policy makers, especially in the Bundesbank, whilst critics of the QE bond buying programme have argued that it mainly props up the Italian government and its large debt burden.
It was little surprise therefore to learn of a unanimous decision by the Council to raise interest rates by 0.75%, the largest increase since the EMU project began, reaching their highest level since 2011. The accompanying ECB’s economic forecasts help explain this, as growth is expected to be weaker but inflation higher into 2023. 2%. President Lagarde went out of her way to sound hawkish at her press conference, leading to speculation that the peak in rates will be closer to 3% than 2%.
UK gilt yields also rose this week, but the outlook for interest rates is rather uncertain. When Bank of England Governor Andrew Bailey was quizzed by MPs on the Treasury Select committee, he emphasised that rates would need to rise to cap inflationary pressures. However, the Bank will need to wait for details of the fiscal package to be announced by the Chancellor later this month. Although Prime Minister Liz Truss has announced a cap on average household energy bills, the details of its financing (costing between £100-200 billion?) and the impact on reducing headline inflation (perhaps by 5%?) remain to be spelled out. The dilemma facing the MPC is clear: on the one hand tax cuts would argue in favour of greater tightening by the Ban, but conversely caps on energy bills should trim inflation expectations. In essence, the government is seeking to boost spending while the BoE is trying to damp demand. Financial markets have expected base rate to rise above 3% by the end of this year and to peak about 4.25% next summer, but the outcome is uncertain.
Now that the ECB has finished its task, attention will turn again to the next FOMC meeting due on 20th and 21st September. The latest employment report had something for everyone, a slight increase in US unemployment but wages still growing too quickly at over 5% year on year. Inflation expectations were bolstered by a fall in oil prices on weak Chinese demand, but surveys suggested that the all-important services sector remained buoyant into August. Nevertheless, the tone and tenor of Fed official statements meant that probability is high of another 0.75% increase in interest rates at the next meeting. The bulk of Fed Governors see a peak about 3.5-3.75% but a significant minority suggest 4.0-4.25% rates will be required to slow the economy.
There was little move in benchmark US bond yields in the past week but there were large moves in UK and to a greater extent German benchmark bonds, as in effect another rate increase was priced into the curve. The net result is that 10 year gilt yields have reached their highest in 9 years whilst yields on 30 year US bonds and thus mortgage rates have reached their highest levels in 8 years. The relay race continues, the debate is on-going, and will continue until there is much clearer economic evidence one way or another
Bond yields at the time of writing this week
% 2 year 5 year 10 year
USA 3.49 3.40 3.29
UK 3.05 3.03 3.18
Germany 1.32 1.58 1.73
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