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About turn, quick march!

Bond markets are enjoying a rather good month. Despite continued warnings from central bankers,  investors are growing confident that interest rates have reached their peak, and even begun to price in actual cuts from summer 2024 onwards. Time to fix that high yield!

The trigger for this improvement in sentiment has been a noticeable slowdown in inflation in October. The US CPI slowed to from 3.7% to 3.2% year on year, with little to worry about in terms of the core rate or the services sector. Similarly, in the UK, October’s CPI slowed to 4.6% from 6.7% a year, as lower gas prices finally had a meaningful impact. Detailed analysis suggests slow declines ahead; services inflation is still running at 6.6% pa, on the back of strong wages growth, and food prices remain a concern. However, a further decline in oil prices below $80 per barrel has restrained global inflation expectations.

Dis-inflationary tendencies should be helped by muted economic activity. After the strength of the US economy in Q3, Q4 got off to a weaker start. Retail sales showed the first modest decline in seven months as student loan repayments resumed. There is evidence that those out of work are experiencing a harder time finding a new job, which chimes with weaker consumer confidence. The official index of leading economic indicators has recorded its 19th consecutive monthly decline, which matches continued weakness in the NFIB small business survey. Elsewhere, Eurozone GDP shrank by 0.1% in the third quarter of the year, and a weak PMI business survey in October suggests no improvement into Q4.  In the UK, GDP was reported flat in Q3 with weaker retail sales although a rebound in services sector activity in November did suggest modest economic growth in Q4. The Bank will keep a watchful eye on news that insolvencies are rising, up 18% in the year to October.

The Autumn Statement caught the attention of many commentators, the starting gun for the 2024 election. However, there was little in it which would worry the Bank of England. Tax cuts of £20 billion are too small to have much impact on a £2 trillion economy, as confirmed by OBR forecasts for very moderate growth for the UK economy for the foreseeable future. Any fiscal largesse should be seen in the context of a regime still on course to take the tax burden up to its highest level in 60 years. The budget deficit is running about 5.5% of GDP, the worst since the depths of the pandemic.

How are central bankers assessing the situation? There has been a plethora of warnings from policy makers that interest rates are on hold for the time being. Jerome Powell continues to make hawkish comments, whilst the latest set of Fed minutes signalled continued caution about making any quick decisions one way or the other. The Bank of England’s chief economist, Huw Pill, warned that price increases will be more persistent than policy-makers expect because pay and inflation in the services sector remain ‘stubbornly high’. Andrew Bailey said it was “far too early to be thinking about rate cuts”, and borrowing costs might have to go up again if there were signs that inflation was proving more persistent than expected… “when inflation is high, we take no chances”. Over in Europe, Christine Lagarde has said the European Central Bank will not begin cutting rates for at least “the next couple of quarters”, whilst Villeroy emphasised rates could be at a plateau for some time. In the latest ECB meeting minutes policymakers insisted on maintaining the possibility of a further rate hike, even if additional tightening was not their primary scenario.

Despite all this talk, the money markets are discounting interest rate cuts. The details vary a little from country to country, possibly starting as soon as May in the USA, more likely August in the UK. The market is settling on four Fed cuts next year adding up to 1% off official rates.

There are hurdles to cross in coming months. Although the US House of Representatives passed a temporary spending bill, there is still the possibility of some form of government shutdown next spring. Geopolitical analysts are keeping a watchful eye on developments in the Middle East. The markets know that they have to absorb increasingly higher amounts of new bonds. Putting such risks aside, bond investors are in a happy mood as Christmas looms.

Bond yields at the time of writing

10 year %                     Weekly Move               Monthly move

USA                              4.42                             -0.12%                          -0.42%

UK                                4.26                             +0.01%                         -0.28%

Germany                      2.62                             +0.03%                         -0.21%

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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