A strong reaction to strong data
This was a week when financial markets were buffeted by a series of economic reports showing strength in the US economy, strength in UK inflation, and a strong response by the Chinese authorities to strengthen its path into 2024. The net result was global bond yields are at their highest level since 2008. Depending on the market and bond maturity, many yields are 0.25% higher than a week ago.
The main area of strength was US retail sales. As well as coming in stronger than expected in July, the best for six months, there was an upward revision to June. Tight credit conditions suggest that consumer spending should slow in coming months but, with additional strength seen from housing starts and industrial production in July, economists are raising their estimates for US Q3 GDP towards 2-3%. Economists also think that headline inflation could stabilise or even edge up in coming months on the back of higher oil prices. The International Energy Agency reported that global oil consumption reached a record level in July, while the Atlanta Fed’s wage growth tracker is holding above 5%.
How is the Federal Reserve seeing the situation? Minutes of the July meeting showed officials were somewhat divided over the need for more rate hikes. A minority were worried about risks to the economy from excessive tightening; a higher cost of capital could lead to accidents in the financial markets. However, “most participants continued to see significant upside risks to inflation, which could require further tightening of monetary policy. As the level of uncertainty remained high, so future interest rate decisions would depend on the “totality” of data arriving in “coming months” to “help clarify the extent to which the disinflation process was continuing”. On balance the minutes were interpreted with a hawkish bias, and yields reacted accordingly.
US and European yields were also affected by the latest Chinese data. It is a difficult situation. A series of depressing reports on the state of China’s housing market, retail sales and industrial production, plus more concerns about the ability of major property developers and enterprises to repay their debt, caused the central bank unexpectedly to cut its benchmark interest rate. As one adviser said “the most urgent goal now is to stimulate household consumption, and it is necessary to use all reasonable, legally compliant and economic channels to put money into residents’ pockets”. The State Council also promised to meet annual economic targets via “targeted and forceful” macroeconomic adjustments and strengthened policy coordination. A slowdown in China’s economy, which is about the same size as the whole of the EU, should encourage the doves in other central banks. However, a major period of policy easing and a stronger Chinese economy into 2024 will not be appreciated by those central bankers in the West desiring to see much slower activity and easier labour markets in the Western economies.
Some data has moderated in the UK. Headline inflation eased to 6.8% from a year ago, helped by much lower energy prices. However, core inflation still as high as 6.9%, led by strong demand for leisure services, will worry MPC hawks. So will the latest labour market report. Although the unemployment rate edged up, there was another month of rapid wages growth, up 8.2% a year. Looking ahead, public sector pay expectations have reached the highest rate since 2012, according to the Chartered Institute of Personnel and Development. The CIPD report also found that private sector employers were being forced to offer strong pay increases in the face of skills shortages and near full employment, and are regularly making counteroffers to staff considering leaving in a bid to hang on to talent. Against such a backdrop, it is no surprise that Governor Andrew Bailey has blamed “unsustainable” pay rises for stoking inflation.
The UK is experiencing a classic ‘stagflation’ situation, that is above trend inflation occurring alongside moderate economic growth. Although output in the UK jumped in June, led by a recovery in car and pharmaceutical production, the second quarter was only 0.2% higher than in Q1; in other words the underlying rate of growth in the UK is still only about 1% a year, reflecting very weak productivity. Nevertheless, markets have priced in another move by the MPC in September and it is 50-50 whether a final one is seen in November or December.
The ECB will pause its rate hiking programme in September, according to a narrow majority of economists polled by Reuters, but a further increase is still expected before year end. As with the UK, core inflation remains too high despite a slow growing economy. The survey also showed that economists expect rate cuts to start in March. Cuts will be limited next year, however, as economists are forecasting tight labour markets, with little change in unemployment between 2023 and 2024.
The rise in bond yields over the past month has been of the order of 0.25-0.5% in many Western markets. The combination of economic strength in some countries, policy decisions to boost activity in others, and tight labour markets supporting core inflation, all suggests interest rates higher for longer. The timing of any rate cuts in 2024 has been pushed back again.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.99 4.35 4.42
UK 5.33 4.80 4.80
Germany 3.09 2.69 2.70
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