The end is in sight!
For months central bankers have warned about that labour markets are unduly tight. Despite slow economic growth, unemployment remains too low, and wage increases too high. However, for those countries where inflation appears on a steady downward path, especially core inflation, then markets are more convinced than ever that the end is in sight to the monetary policy tightening cycle.
There is sufficient evidence to justify another interest rate move by the Federal Reserve in July, taking interest rates to a 22 year high. Yet the debate is wide open about whether it will act again in September. Undoubtedly, the latest US monthly payrolls report, generally recognised as the single most influential US economic statistic, was a worrying one. Although employment only grew by 209,000, a little lower than the average 278,000 so far this year, that was solid enough to take the unemployment rate down again to 3.6%. More importantly for Fed hawks, wages growth picked up to 4.4% from a year ago. As one economist summed it up “that kind of labour market strength suggests that the Fed may need to keep interest rates higher for longer than markets previously anticipated.”
Although US wages growth remains too high, companies are being forced to take the pressure on their margins in the face of an economy only growing 1-2% a year. Hence, the latest CPI inflation had a dramatic effect on market expectations. The headline rate fell to 3.0%, the lowest since March 2021, and the core rate excluding food and energy eased to 4.8%, helped by sharp declines in airfares, hotel charges and second hand car prices. There is more good news in the pipeline, as food price inflation has moderated, whilst prices of intermediate (or producer price) goods for businesses have weakened sharply. Anecdotal evidence from the Beige Book Fed survey indicates more companies are reluctant to raise prices because consumers were more sensitive about price increases. A research paper from the Federal Reserve also caught the attention of many economists. It indicated that a measure of the tightness of overall financial conditions is approaching the peaks seen in 2008, encouraging some investors to think that the peak of the current monetary tightening cycle must be seen soon. Against this background, Fed Governor Christopher Waller stated the obvious that such helpful inflation news meant a second further rate increase was by no means certain.
The key data for the gilts market this week was also the latest UK labour market report. Although unemployment edged up in the UK last month, average earnings are still growing at 7.3% a year, albeit some of that may be related to increases in the national living wage. MPC doves will point to some signs of improvement in labour demand vs supply. A recent Bank of England survey found the proportion of firms finding it harder to recruit was the lowest since October 2021, partly reflecting extra immigration. Companies are planning to increase wages by 5.3% in the coming year, down from the expectations of 6.3% made last December. Another positive sign came from a Recruitment and Employment Confederation/KPMG survey, which reported that increases in starting salaries for permanent and temporary staff were the weakest since April 2021. There was a sharp upturn in people looking for work reflecting a drop in recruitment and increasing redundancies.
Nonetheless, wages growth so far ahead of the central bank target, and comments from the Governor and the Chancellor in their Mansion House speeches about the danger of inflation expectations becoming ingrained as firms are resetting prices more frequently, must indicate that the MPC moves again in August. The only question is whether it is by 0.25% or 0.5%, which may depend on next week’s CPI inflation report; 2 year mortgage rates topped 6.6%, and the pound reached a 15 month high as a consequence.
Although there was little important EU economic data this week, generally showing slow but stable economic growth into Q2, statements from ECB officials reinforced existing market thinking. Minutes of the most recent ECB meeting reinforced the view that the bank will act twice more over the summer concerned as it is about core inflation. Francois Villeroy said the central bank is almost finished hiking, but that rates will remain on a “high plateau” to ensure they fully impact the economy.
Over the past week, US bond yields have fallen back by about 0.25% as investors consider the end must be in sight for Fed tightening. Such a move did drag down bond yields across Europe as well. However, the 2% gap between UK gilt and German bond yields shows the strength of the inflation pressures seen in this country, and market expectations that the Bank of England needs to do rather more before the end is in sight.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.70 4.00 3.78
UK 5.25 4.62 4.47
Germany 3.25 2.62 2.48
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