Blowing too hot or too cold
Bond yields were warmed by some news this past week. There was more positive talk between the President and the US Senate that some form of agreement could be reached on the debt ceiling, removing a potential risk to financial markets. Conversely, there were few signs that the world economy is cooling rapidly. The net result was bond yields generally backed up, indeed the benchmark US 10 year bond was its highest since March.
In most countries, the latest data indicates that labour markets remain tight, suggesting core inflation will not fall away quickly. Nor are there many signs of the much anticipated recession in any of the major economies, which could force their central banks to shift to an easier stance. US economic growth has got off to a warm start in Q2, with another solid increase in retail sales. It still appears that household savings and high levels of employment and credit growth provide the wherewithal needed to go to the shopping mall. Admittedly there are a few early warning signs, with some regions reporting a sharp decline in job postings, whilst certain regional bank surveys showed credit tightening accelerating through May. One of the Fed Governors who spoke this week, Raphael Bostic, said he was inclined ”to pause further rate hikes to see what impact they are having, as businesses are telling him that the Fed is “close to overdoing it”.
However, he looks to be outvoted by others who are much more of the view that the economy is not yet chilled enough to justify a change in stance. To give a few examples, James Bullard considers that monetary policy is barely in the zone of being restrictive enough. He was joined by Tom Barkin who warned that “we’re going to need more impact on demand to bring inflation down to where we need to go”. Neel Kashkari said he thinks the central bank has “more work to do on our end to try to bring inflation back down”. Lastly, Loretta Mester explained she does not think the central bank is at a point where it can hold rates steady given how stubborn inflation is. Against such a backdrop, the financial markets are still pricing in another Fed rate increase in June.
As the UK economy is growing so modestly, there are some signs that the labour market is finally cooling. The unemployment rate in April ticked up to 3.9%, as payroll employment fell in April for the first time in over two years. However, average earnings excluding bonuses still rose 6.7% in Q1 compared with a year earlier. Nor will the Bank like the news from the Chartered Institute of Personnel Development. It warned that median pay settlements in the public sector were showing the highest rates in a decade, whilst those in the private sector were still running at over 5%. “The labour market may have become less competitive in recent months but there is still strong demand for workers across the economy”.
Against such a backdrop, it was no great surprise to see Andrew Bailey, the Governor, emphasising that the MPC is closely watching the labour market for any long lasting effects trickling through into wages and services sector inflation. Chief Economist Huw Pill took a similar line when he warned that “the risk is that self-sustaining, second round effect momentum within the UK economy keeps inflation running at above target levels”. Markets are debating whether there will be one or two more moves by the MPC before it pauses and assesses the situation.
A limited amount of economic data across the Eurozone this week matched the overall trends seen in the USA and the UK. There was a third successive drop for the German ZEW business confidence index, mirroring weakness in the manufacturing sector. However, labour markets in Europe remain tight; French unemployment at 7% remains the lowest seen since 2007-08. As a result, central bankers continue to talk warmly about the need for further action. ECB policymaker Peter Kazmir said “I am convinced that there are more meetings ahead of us where we will decide on raising rates and I think we will raise them further. Headline inflation in the euro zone sometimes falls and then rises again a bit but the key point is that core inflation is still creeping up”. He will be very aware that the European Union raised its official forecast for euro-area inflation outlook to 5.8% this year and 2.8% in 2024, warning of “persistent challenges.”
Financial markets have been blowing hot and cold, therefore, wondering whether the debt ceiling debate in the USA will boil over, or labour markets in the major economies will start to cool down. There may be a new factor appearing, however, which could complicate central bank forecasts about the future path of inflation. Scientists warned this week that the world is almost certain to experience new record temperatures in the next five years, whilst temperatures are likely to rise by more than 1.5C above pre-industrial levels. Standard economic models will find it very difficult to analyse what such developments might mean for such issues as food and raw materials supplies and prices, or mass migration as populations seek cooler climes. Whether an economy is growing hot or cold increasingly needs to be analysed in terms of climate change as much as the state of the labour market or consumer supply & demand.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.26 3.69 3.66
UK 3.97 3.80 3.97
Germany 2.81 2.44 2.47
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