You pause if you want to, the Lady is not for turning
A noticeable gap is appearing between benchmark bond yields in the UK, the USA and Europe. 10 year yields have reached 4.4% in the UK, but only 3.8% in the States and 2.5% for Germany. Although inflation is much higher than any central bank would like to see, the realisation is growing that the UK faces particular circumstances. Hence, the yield on UK 2 year gilts has moved from 3.7% to 4.5% within a month, as more economists forecast that the peak in UK base rates might be closer to 5.25-5.5%.
The key trigger for this reappraisal was the latest CPI report. The good news was that headline inflation fell from 10.1% to 8.7% as the spike in oil prices seen a year ago fell out of the 12 month calculations. Looking ahead, energy costs should fall further for most households in July as the regulator Ofgem announced a cut in the price cap. However, there was much bad news elsewhere. The strength of underlying pressures was shown by the CPI index rising at an annualised rate of 13% in the past three months. This was partly due to very strong food prices, up 19% from a year ago. While some of that reflects climate problems affecting agriculture, say in Spain, some is structural. The LSE has published research arguing that Brexit trade barriers contributed about one third of the rise in food prices between 2019 and 2023. Lastly, wage pressures are noticeably feeding through into core inflation which rose from 6.2% to 6.8% in April, the highest level since March 1992.
Problems facing the gilts market did not stop there. Questions can be asked about monetary policy. After all, Governor Andrew Bailey admitted that the Bank’s inflation model is not working well, largely due to structural changes taking place in the labour market but also excessive corporate profitability. In one respect, the economy is growing slowly despite high levels of immigration which should alleviate a tight labour market. Questions can also be asked about fiscal policy. Public sector borrowing was robust at £26 billion in April, taking the rolling 12 month deficit to almost £150 billion which is close to 6% of GDP.
The global backdrop to the domestic gilts market was unhelpful as well. US benchmark bond yields are 0.5% higher than they were six months ago. In the short-term, this partly reflects concern amongst overseas investors about the possibility of a default on US debt, or some sort of crisis related to the intricate negotiations over the debt ceiling, True, there did appear to be some sort of progress this week in terms of the negotiations between Biden and Senate leader McCarthy. However, credit rating agency Fitch reminded investors of the risks when it placed the US sovereign debt on negative watch, aggravating stress in parts of the US financial system.
There was also a reappraisal about the prospects for US interest rates, albeit less so than in the UK. The latest set of minutes of Federal Reserve discussions showed the usual split between those who think the Fed has done enough and those who see the need for more action. On balance, however, the consensus has shifted to the view that after a pause in June, the Fed might move again at its July meeting, and any cuts by year end would be moderate. Fed Chair Jerome Powell gave his usual even handed explanations. As the FOMC had “come a long way in policy tightening” and “as policy has become more restrictive, the risks of doing too much versus doing too little are becoming more balanced and our policy adjusted to reflect that”. However, “we face uncertainty about the lagged effects of our tightening so far, and about the extent of credit tightening from recent banking stresses…so today, our guidance is limited to identifying the factors we’ll be monitoring as we assess the extent to which additional policy firming may be appropriate”. In this context, it is worth noting that US economists are raising their estimates for US core inflation at year end back towards 4%.
Against this backdrop, European bond yields are noticeably lower than in the UK. It is the case that the markets expect a few more rate increases by the ECB. Christine Lagarde reinforced such a view when she said the “ECB isn’t pausing based on the information I have today,” as the inflation outlook appears too high for too long. Pabio Hernandez concurred that “the process of tightening monetary policy is well underway, although we have some way to go….interest rates will have to remain in restrictive territory for an extended period of time to achieve our objective in a sustained manner”. Bundesbank President Joachim Nagel similarly said “several more interest rate steps will be needed to reach a sufficiently restrictive level, and we will then have to maintain this level for a sufficiently long time until inflation has fallen sustainably. Rest assured that I will not let up until price stability is restored”.
Putting such statements into perspective was the news that the German economy was in a modest recession over the winter months. Together with growing evidence that European exports are reacting to a slowing Chinese economy, this reminded investors that a weak economic backdrop should start rippling through into labour markets.
Indeed, the key question for bond investors remains whether the world economy decelerates sufficiently to bring inflation sustainably on a path towards the central bank targets. Here the news is mixed. Certainly a slowdown is being seen in indicators such as housing markets and container shipping statistics. Notably, business surveys suggest that manufacturing output is declining in most countries; indeed the Eurozone PMI factory survey fell to the lowest level since May 2020. However, in most countries consumer spending is propped up by excess household savings, credit growth and high levels of employment. Hence the services sector remains strong, for example a figure of 55 in the global PMI survey indicating a solid expansion. The future pace of economic growth, or the length and depth of any recession, really matters; it is difficult to see how inflation can be tamed without a significant rise in unemployment.
Averaging the official interest rates across all the major economies, these have risen from about zero at the start of 2023 to about 3.7% in May, and look set for 4% by the summer. Further moves towards 5% will depend on the complicated battle between growth and inflation pressures. The Old Lady of Threadneedle Street is currently front and centre in this war.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.42 3.82 3.76
UK 4.51 4.29 4.36
Germany 2.90 2.48 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