The fog lifts, full speed ahead
On some occasions, central bankers face a fog of mixed economic and financial data, and ponder which way to move. When the fog lifts, and clarity appears, then time to act – and bond markets have certainly responded!
The Bank of England is entering its quiet period ahead of the next MPC meeting on 22 June. It would be a major surprise though if it does not increase interest rates, indeed the markets are pricing in another four rate moves by year end. The decisive news was the latest employment report, after which Governor Andrew Bailey admitted “as I’m afraid this morning’s numbers illustrated, we’ve got a very tight labour market in this country…we’ve had a fall in the supply of labour, which is showing signs of recovering, but very slowly, frankly…We still think the rate of inflation is going to come down, but its taking a lot longer than expected”.
The statistics were indeed a concern. Wage inflation moved higher, reaching 7.5% from a year ago, so their fastest pace on record outside of the pandemic. The only good news is that part of the uptrend was due to higher minimum wages, whilst the Bank’s own survey of chief financial officers points to a marked slowdown in pay growth over the coming months. However, at the same time the unemployment rate fell again, to 3.5-75% depending on the measure. The economy may be expanding slowly, about 1% a year, but the withdrawal of so many potential workers from the labour force, partly for health reasons, means the remainder can seek higher compensation. It was not a great surprise, therefore, that short-dated gilt yields jumped above the levels seen in the wake of the ill-fated mini-budget last year. The impact on the mortgage market has dominated the business news all week. The debate begins again then on how much UK rates are moving into restrictive territory, and whether that means another 1% on interest rates by year end is actually sensible.
The Federal Reserve was also a model of clarity. The debate in recent weeks had been about whether the central bank would pause in June and what it would indicate about future policy. In the event, the Fed paused its rate hikes as expected, but pushed its projection for interest rates at year end up by 0.5%, perhaps hiking every other meeting. US bond yields generally rose as the market also moderated its expectations for rate cuts next year. Part of the rationale for lower rates was hopes that financial conditions would tighten in the wake of spring’s bank failures. That does not appear to be happening. Indeed Jerome Powell admitted that the drag from interest-sensitive spending, especially in housing, has been neither as powerful nor as sustained as had been expected.
The latest consumer inflation report can also help explain why the Fed expressed those views. The headline rate fell back to 4.0% from a year ago, compared with a rate above 9% this time last year. Lower energy and food prices are certainly helping consumers, down over 3% from a year ago. This may also help explain why inflation expectations are easing according to the NY Fed’s consumer survey. On the other hand, the core rate excluding food and energy was still as high as 5.3%. This chimes with the latest report from the Atlanta Fed indicating that wages growth remains steady about 6% a year. In terms of economic growth, the latest retail sales report hints that US looks set to be expanding about 2% a year. Within this, the NFIB small business survey continued to show weaker manufacturing and stronger services sector activity ahead, on balance positive for future hiring.
Moderate US economic growth is also feeding through into a growing fiscal deficit, as revenues are down from a year ago. The 12 month cumulative deficit has reached 8.5% of GDP. A flood of Treasury debt is about to hit the market as the US Treasury rebuilds its cash buffers now that the debt ceiling showdown has ended.
There was some debate about whether the ECB would follow the Fed with a pause this week, but in the event there was another hawkish decision – a 0.25% hike, and strong hints that the same would be seen in July. As Christine Lagarde explained rate-setters “still have ground to cover” and “I can tell you that barring a material change to our baseline, it is very likely the case that we will continue to increase rates in July”. The latest industrial production report signalled that the Eurozone is growing moderately in 2023, and indeed the ECB has become a little more positive about growth in 2023-25, which should keep labour markets tight. Hence it forecasts that core inflation will average about 5% in 2023, before declining to 3% in 2024. The ECB will also be very aware of decisions being taken in the world’s second largest economy, China. Weak money supply growth was the trigger for a small rate cut by the Chinese central bank, expected to be the first in a series in coming months to sustain a flagging economy. Further acceleration in the Chinese economy will encourage the ECB to watch for any signs of strength in European trade and hence manufacturing.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.63 3.92 3.73
UK 4.94 4.56 4.41
Germany 3.16 2.61 2.50
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