0.5% and 0.5% and 1% – is that enough?
The combination of hawkish speeches from central bankers and a steady stream of positive economic activity keeps the pressure on bond markets. The US and German 2 year bond yields have both risen by 0.5% over the past month, and the UK 2 year yield is 1% higher than a month ago. Markets anticipate that the Federal Reserve and ECB will raise interest rates at least two more times, and are speculating that the peak in UK interest rates might be over 6%, perhaps reaching 6.5%.
Economic growth is slow or decelerating, depending on the economy, but core inflation remains too persistent, as speaker after speaker made clear at the SIntra central banker conference last week.
The focus of economic weakness is clearly in the manufacturing sector in all countries. This month’s surveys showed that the global manufacturing PMI measure fell again in June to just under 48, led by the USA (down to 46) and Germany (down to 41). However, manufacturing is a small part of most developed economies, and far more important is continued strength in consumer spending and services. The service sector PMIs in June were mostly at healthy levels, often approaching 55 in June.
There was some hope for Fed doves as its favourite measure of inflation, entitled core PCE, has slowed to 4.6% a year. However, the balance of Fed Governors clearly still consider that more action is required. The minutes of the June meeting discussed all the factors well aired in recent Fed speeches: concern that inflation was unacceptably high and declining more slowly than had been expected, yes the economy was decelerating, but banking stress had receded and hence continued slow growth was just as likely as a mild recession. All in all, a pause in June was sensible to allow the Committee to gather more information on the effects of cumulative tightening and assess their implications for policy. The pause will not last long though. As the Financial Times summed up the discussion “Federal Reserve officials signalled they intend to resume interest rate increases amid a growing consensus that more tightening is needed to stamp out high inflation in the world’s largest economy”. Subsequently, a stronger than expected ADP employment survey for July cemented such a view, taking US 2 year yields to their highest since 2007.
Core inflation also remains sufficiently high to warrant another ECB rate hike. ECB hawks and doves can point to different aspects of the latest economic reports. While the annual inflation rate dropped to 5.5% in June, core inflation ticked back up to 5.4%. Wages are supported by Eurozone unemployment at its lowest for over 15 years, although there are signs that the slowdown in German manufacturing is feeding through to higher unemployment. The balance of the discussion at the Sintra central bank conference, and subsequent comments from the likes of Joachim Nagel warning that “monetary policy signals are clearly pointing in the direction of more tightening”, all encouraged the markets to price in at least two more ECB rate hikes this year.
Trends in UK manufacturing and service sector surveys broadly match their counterparts in other countries. The economy continues to grow modestly, and labour markets are too tight for the likes of the Bank of England. Markets also noticed with interest comments from Megan Greene, who is joining the MPC. She said “it would be a mistake for central bankers to take comfort in the notion that inflation and rates will automatically go back to the low levels we saw before the pandemic. This is their challenge for the future”. Traders are pricing in a terminal rate of 6.25-6.5% by the end of the first quarter of next year, which would be the highest since 1998.
Last week, the BIS warned about the worrying situation facing the world economy. This week the IMF joined in, as Gita Gopinath talked about three uncomfortable truths. The first is that inflation is taking too long to get back to target, because policy is less effective than in the past. In the case of the UK, for example, only a minority of mortgage holders are on a floating rate, whilst household savings are historically high. The second uncomfortable truth is that financial stresses could generate tensions between central banks’ price and financial-stability objectives. In this respect, there was interesting Federal Reserve research which warned that there are a growing number of companies in financial distress. The third uncomfortable truth is that central banks are likely to experience more upside inflation risks in the future, as well as a risk of inflation expectations de-anchoring. Gopinath spoke of an “incredibly narrow” path that would allow for the tightness in goods and labour markets to unwind without rates rising much more. Will another 0.5% in the case of the USA and EU be sufficient, or is the UK pointing the way with traders suggesting that rates might need to rise another 1.0-1.5% to bring the situation under control?
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 5.04 4.39 4.06
UK 5.56 4.96 4.70
Germany 3.34 2.78 2.62
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