Summer doldrums
As central bankers have repeated ad nauseam, they are closely watching the data to decide what to do next. This week’s economic reports suggested that growth and inflation are both decelerating slowly, and hence that central banks are one step closer to keeping monetary policy on hold.
The most important announcement was the US inflation report for July. Although headline inflation edged up to 3.2% from a year earlier, partly due to more expensive gasoline, markets were reassured by the continued slowdown in the core CPI. This eased to 4.7% in the year to July, its lowest since October 2021. Such a downtrend matches other reports. July’s labour market statistics showed a steady deceleration in employment growth. It is the case that wages are growing faster than the Federal Reserve would like to see; surveys suggest that robust demand for workers from small and medium enterprises is keeping unemployment low. However, the combination of all those reports encouraged the markets to expect the Fed to stand still in September, and perhaps move for the last time in November.
The debate remains wide open at the Federal Reserve. Michelle Bowman is worried “I expect that additional rate increases will likely be needed to get inflation on a path down to the FOMC’s 2% target”. Conversely, Patrick Harker believes that “we may be at the point where we can be patient and hold rates steady and let the monetary policy actions we have taken do their work”. However, he also explained that “we will need to be there for a while. The pandemic taught us to never say never, but I do not foresee any likely circumstance for an immediate easing of the policy rate”.
One reason for the Fed remaining on hold is the length of time it takes for interest rates to affect a modern economy. Statisticians reported that US households had to pay $150 billion more on interest payments on mortgages, credit cards and other loans in the year to June. However, this was partially offset by American households also earning an additional $120 billion in interest on savings, whilst many have also benefitted from the sharp rise in the stock market so far this year.
Although growth and inflation are the prime drivers of bond markets, investors are also concerned about debt and politics. Considerable attention has been paid to the surge in new bonds being issued by the government – official forecasts suggest it could be as high as $1.5-2.0tn over the coming few years, when the Fed is no longer actively buying bonds with its QE programme. The 2024 US Presidential election also looms ahead, with Trump & Biden neck & neck in the polls. The credit rating agency Fitch explained its recent downgrade of US sovereign debt was partly due to increasing political dysfunction which has led to repeated government shutdowns and debt-ceiling standoffs.
UK and European bond yields were pulled a little lower by the US inflation news, but otherwise domestic data was too muted to spark any major change in direction. The Eurozone looks set to grow slowly over the summer. Weak retail sales figures demonstrate the continued cost of living squeeze, whilst reports from container shipping companies illustrate the doldrums in world trade. The ECB puts considerable emphasis on inflation expectations. The good news is that consumer expectations for future inflation showed another decline, with those for three years ahead easing from 2.5% to 2.3%. However, the ECB will also be aware that inflation expectations as priced into the bond markets touched new highs of 2.7% last week. Such news keeps the door open for another ECB rate hike before year end.
UK gilt yields also moved little this week. Economic statistics also suggest a slow growing economy. Consumer demand is weak, as reported by the British Retail Consortium in July, although such wet weather cannot have helped. The latest RICS housing survey was also downbeat, whilst a REC employment survey suggests that unemployment should edge higher in coming months. Some economists are very bearish. The National Institute of Economic & Social Research caught the headlines with warnings that there is a 60% chance that the UK enters recession in 2024, whilst inflation will not fall back to the Bank of England’s 2% target until after 2025 as the economy is suffering from a 1970s-style ‘British disease’. Despite such downbeat news, the lack of movement in gilt yields also suggests that investors have bought into the Bank’s view that interest rates must remain above 5% for several years to prevent higher wages and prices becoming embedded in the economy. Investors may also be paying attention to recent signals from the Bank that it could sell as much as £300 billion or one third of its gilt holdings back into the marketplace over the next two years. Who will buy and at what price?
After volatile movements in bond yields earlier in the year, July & August demonstrate a summer lull. UK 10 year gilt yields are only 0.25% lower than a month ago, German about 0.15% lower, whilst US 10 year debt is largely unchanged. External factors could spark a change in direction in the autumn. The first is the rise in oil prices, now their highest since January, due to OPEC supply cuts, plus higher food prices, as the Ukraine-Russia war heats up. A second factor could be decisive action by the Chinese authorities to stimulate their economy. Further poor trade data and falls in consumer prices suggest that the slowdown in America and Europe, on top of China’s well documented debt problems, are impacting the world’s second largest economy. The summer doldrums will eventually end, but the nature of the autumn storms remains to be seen.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.78 4.14 4.03
UK 4.958 4.448 4.41
Germany 3.11 2.559 2.505
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