Coping with some unpleasant surprises
As banking sector worries die down, investors and central bankers are turning their attention back towards labour markets, hoping for clear signs that a slowdown in the world economy is feeding through into lower wages and hence inflation. Sadly such evidence is just not appearing, and as a result bond yields have moved higher over the last month.
Some of the largest increases were seen in the UK. A weaker economy has caused the unemployment rate to reach 3.8% in March. However, continued competition for a limited pool of workers meant average weekly earnings rose 5.9% from a year ago, versus expectations closer to 5%. The other disappointing news was headline inflation, remaining above 10% for a 7th successive month in March. Although energy prices fell back, food inflation moved closer to 20%. Stripping out volatile aspects, the core rate of inflation was unchanged at 6.2%. The headline inflation rate in the UK has dropped just 1% from its October peak, in contrast to declines of 3-4% experienced in the other major economies.
Other surveys gave mixed messages about the future path for the UK economy. Chief Financial Officers of the UK’s largest firms reported the largest increase in confidence since the country emerged from lockdowns in autumn 2020. Conversely, the MPC will be wary of the impact of previous monetary tightening and the cost of living squeeze. UK banks reported a 14% increase in defaults of loans and mortgages by households and businesses in the three months to February due to higher borrowing costs. Amalgamating all this data, market expectations for the peak in UK interest rates are moving back towards 5% by the summer.
Data flow for the United States also remains mixed. The Atlanta Fed’s wage growth tracker jumped to 6.4% a year in March, too elevated for the likes of many at the Fed. While jobless claims numbers have risen, they remain historically low. Market attention was drawn to the University of Michigan consumer sentiment report, where inflation expectations for the next twelve months were back up to 4.6%. Conversely, doves at the Fed were reassured by the relatively downbeat retail sales report for March. “Households are clearly feeling the pinch from rising interest rates and the extended period of high inflation and are reducing expenses to compensate”, said Nationwide. “While job and income gains remain strong, the cracks in the consumer sector are widening and a negative shift in hiring activity could be the final blow to place the economy in recession”. Nevertheless, the US economy still looks on course for positive growth of around 2% a year in the first quarter.
Some Fed governors are closer to halting than others. “Let’s just be mindful that we’ve raised a lot, it takes time for that to work through the system”, said Austan Goolsbee. Conversely, James Bullard argued the Fed should continue to raise rates. “Wall Street’s very engaged in the idea there’s going to be a recession in six months or something, but that isn’t really the way you would read an expansion like this… the labour market just seems very, very strong. He felt “the bias (on interest rates) would be higher for longer” to ensure inflation is fully under control.
Money supply data will be examined closely into the summer. As US Treasury Secretary Janet Yellen explained “Banks are likely to become somewhat more cautious in this environment… we already saw some tightening of lending standards in the banking system prior to that episode, and there may be some more to come”. She said that would lead to a restriction in credit that “could be a substitute for further interest rate hikes that the Fed needs to make”. Federal Reserve President Williams echoed those comments; “these developments will likely lead to some tightening in credit conditions for households and businesses, which in turn will weigh on spending” but “It is still too early to gauge the magnitude and duration of these effects, and I will be closely monitoring the evolution of credit conditions and their potential effects on the economy”.
It is widely expected that the ECB will raise rates in May. Christine Lagarde explained once again that “resilient labour markets and strong wage growth, especially in advanced economies, suggest that underlying inflationary pressures remain strong.” ECB chief economist Philip Lane emphasised that ECB’s Bank Lending Survey due on 2nd May will be important to determine whether the move is 0.25% or 0.5%. “That’s the most important survey for us in understanding whether we are indeed seeing further tightening of credit conditions”.
Arguments are growing, however, that the move in May need not be the last. Dutch central bank governor Klaas Knot said the ECB may have to raise rates in May, June and July. “It’s too early to talk about a pause. I would really need to see a convincing reversal in underlying inflation dynamics. We are now in what I would call mildly restrictive territory with policy rates but inflation is still much too high. Where is sufficiently restrictive? I don’t know but clearly not where we are today”. One fact supporting such a stance is the economic recovery being seen in China, with first quarter GDP up 4.5% a year. European exporters should particularly benefit from the jump being seen in Chinese consumer spending.
The difficult balancing act facing central banks was complicated by the latest report from the Bank for International Settlements. It has warned that years of fighting economic crises have created dangerously high levels of public and private sector debt, threatening stability within the international financial system. Central banks face large losses on bond portfolios, and governments are increasingly concerned about their rising interest bill. The BIS warns that banking stress often breaks out roughly 3 years after the start of a coordinated global interest rate hiking cycle.
Moving into the second quarter, the conundrum facing markets and central bankers remains the same. Investors hope that a rising unemployment rate will be enough to bring wages growth down and signal to central banks that they have done enough hiking. However, the jury is still out, and pending a new shock such as a US debt ceiling crisis, then the data flow is forcing market expectations to readjust. UK 2 year gilt yields are almost 0.5% higher than a month ago.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.18 3.64 3.54
UK 3.73 3.63 3.78
Germany 2.90 2.49 2.44
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