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‘Watch and wait’ are the key messages.

UK benchmark gilt yields have reached their highest level since 2008. This partly reflects local conditions, but especially a response to tighter monetary conditions around the world. US 2 year bond yields reached a 17 year high this week, and 10 year yields are approaching 5% again, on news that the US and Chinese economies are growing apace, whilst the Middle Eastern crisis pushes oil prices higher.

For those Fed Governors who focus more on strong payrolls, consumer spending and inflation reports then another interest rate move in November or December cannot be ruled out. The Atlanta Fed’s wage growth tracker eased in September but remained above 5%. This is partly explained by the strength of the US economy into Q3; retail sales data has encouraged economists to raise their estimates towards 4% a year. This is occurring despite flat manufacturing activity whilst housing is increasingly constrained by 8% mortgage rates, the highest rates since 2000.

How does the Fed see the situation? ‘Watch and wait’ seem to be its watchwords. For example, Thomas Barkin said higher longer term borrowing costs are putting downward pressure on demand, but it is unclear how that will affect policy rates. Patrick Harker believes that “absent a stark turn in what I see in the data and hear from contacts, I believe that we are at a point where we can hold rates where they are”. However, “it will be some time for the full impact of the higher rates to be felt”, adding that “holding rates steady will let monetary policy do its work”.  Federal Reserve Chair Jerome Powell indicated that he is pleased with inflation’s decline this summer and that the central bank is unlikely to raise interest rates again unless it sees clear evidence that stronger economic activity jeopardizes such progress. He also noted that the resilience of the US economy to restrictive monetary policy could suggest that neutral interest rates may have shifted higher.

UK gilt yields were also bolstered by labour market and inflation statistics which suggest no need for the MPC to alter policy soon. Strong employment demand, as shown by high levels of vacancies, means that wages remain about 8% higher than a year earlier. Higher energy costs prevented any further decline in the CPI, which remained stuck at 6.7% a year in September, with core almost unchanged at 6.1%. Perhaps market expectations will change next month. The energy price cap should help CPI to fall in October, and MPC member Swati Dhingra said she expects a “letting up” of wage pressures will lead to a further moderation in inflation. This should be helped by the weak state of the economy. The consultancy E&Y forecast that UK GDP growth will only be about 0.6% next year, just skirting recession. A recent IFS report argued that the economy remains stuck between weak growth on the one hand and the risk of persistently high inflation on the other However, recent comments from Andrew Bailey reinforce the consensus view that the Bank looks unlikely to ease until it is much more certain that inflation has been brought under control.

European bond yields have also been dragged up by international influences. For example, French benchmark bond yields are their highest since 2012. This is despite weak business confidence meaning France is on course for modest economic growth, only about 1% a year according to the INSEE. Economists continue to downgrade their forecasts for the euro-area as a whole towards 0.7% in 2024.

The market similarly sees little chance of another ECB rate hike this year, nor any large rate cuts next. This is supported by recent statements from the likes of Bundesbank President Joachim Nagel. Euro zone inflation is coming down, but still far too high, and likely to be above target well into 2025, so monetary policy needs to restrict economic output for the foreseeable future. Of course there are local risks; as ECB member Luis de Guindos said, “The euro area financial stability is fragile, as the financial system adapts to a higher interest rate environment”. Nevertheless, for the time being bond yields are edging higher whilst central bankers assess the situation and try to determine the next major path for the world economy.

Bond yields at the time of writing

%                                 2 year                           5 year                           10 year

USA                              5.22                             4.96                             4.94

UK                                4.99                             4.73                             4.70

Germany                      3.256                            2.835                            2.92

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.

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