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A deceptive calm

Over the course of the past week, bond yields have apparently moved little. However, there were considerable daily fluctuations as the financial markets reacted to a torrent of economic and political news, pulling investors first one way and then another.

The main geopolitical concern is the Hames/Israeli conflict, of course. Political analysts are busy trying to keep up with developments, amidst much speculation about whether the war can be contained or seeps across more of the Middle East. The oil price is generally seen as the best measure to watch, oscillating just under $90 per barrel after threatening to reach $100 recently.

The unexpected assault by Hamas caused a sharp shift in market sentiment, with many investors rushing for safe haven assets. Such a move was book ended, however, by evidence of stronger than expected US growth and inflation data. The employment report for September was solid, as  American companies have hired almost ¾ million workers in the past few months. This reflects the acceleration in economic growth seen into Q3, with GDP estimates in a 3-4% range, even though there are signs that tightening credit conditions will cause slower activity into year end. Headline CPI inflation also rose a little more than expected in September, keeping the annual rate at 3.7%, with more evidence of price rises seeping through the manufacturing sector too.

How is the Fed reacting? The latest set of Fed minutes strongly indicated that the central bank was carefully watching the data; however, this has been overtaken by the surge in bond yields over the past month. In a series of speeches from Fed officials this week, they expressed little concern about bond movements, on the grounds that they would help in the fight against inflation. As Jefferson said “Looking ahead, I will remain cognizant of the tightening in financial conditions through higher bond yields and will keep that in mind as I assess the future path of policy”. Kashkari argued that “It’s certainly possible that higher long-term yields may do some of the work for us in terms of bringing inflation back down”.

Others at the Fed were more analytical in their approach, trying to discern whether the uptrend in bond yields reflected the underlying momentum of the economy or instead changes in investor attitudes toward risk and uncertainty. In technical terms, a bond yield comprises several components such as inflation expectations, the real interest rate, or a risk premium. There is some evidence that the large budget deficit, and the political logjam in Congress, are worrying investors, especially when neither the Federal Reserve nor the Chinese government are buying US bonds to any great degree. Already more than $1.75 trillion of Treasurys has been issued on a net basis through September, higher than in any full year in the past decade, excluding 2020’s pandemic surge.

On balance, the market thinks that the Federal Reserve will remain on hold for the foreseeable future, but expectations for interest rates at end 2024 are slowly edging higher against this backdrop.

The divergence between strong economic activity in the USA and weaker activity elsewhere remains very pronounced. China returned from the Golden Week holidays with domestic consumer spending only slightly higher than in the same period in 2019. German industrial production remains on a downward path, restrained both by exports and consumer spending. On some measures, financial conditions across the Eurozone have not been this tight since the global financial crisis.

Nevertheless, the ECB remains on hold. Joachim Nagel at the Bundesbank noted “Inflation is now falling again, but the greedy beast has yet to be defeated”, whilst he was concerned about the very high rate of core inflation. Klaas Knot considered “that policy at this moment is in a good place but we will remain vigilant and we stand ready to adjust interest rates even more if the disinflation process were to stall”.

Doves at the Bank of England would have noted general tightening of monetary conditions around the world, and further evidence of weakness in the UK economy. Starting salaries rose at their slowest pace in over two according to a survey by KPMG/REC.  The amount of money spent in stores only climbed moderately in September, according to a survey by the BRC and KPMG. GDP growth is only running at an annualised rate of 1.2% going into the autumn. However, the Bank will also note the views of the IMF by signalling that further increase interest rates may be needed as the UK grapples with high inflation. Headline consumer price inflation will stand at 7.7% this year and only drop to 3.7% in 2024, amongst the highest in the G7 economies. If such IMF forecasts are correct, then definitely the calm before the storm.

Bond yields at the time of writing

%                                 2 year                           5 year                           10 year

USA                              5.07                             4.69                             4.69

UK                                4.87                             4.49                             4.45

Germany                      3.13                             2.69                             2.75

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.



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