A different picture, depending on your perspective
If an investor looks at the performance over the past week of benchmark bond yields in the UK, the USA and Europe, then the changes have only been small. Bond markets continue to price in some slowdown in the economy, weaker inflation, and eventual rate cuts. However, if they turned their attention to what is happening with 3 and 6 month interest rates, then the story is rather different. In brief, worries about banking sector and debt ceiling problems are appearing again.
The Federal Reserve and the ECB are widely expected to raise interest rates at their next meeting. The debate is much more whether the move is 0.25% or (less likely) 0.5%. Starting with the ECB, then the latest business surveys are upbeat. The Purchasing Manager PMI survey rose from 53.7 to 54.1 led by a better services sector offsetting manufacturing weakness. A separate European Commission economic sentiment indicator stabilised in April, again as buoyant services offset struggling manufacturing. Lastly, Germany’s Ifo report encouraged the view that industry can avoid recession for the time being. All food for the hawks, expect that the ECB’s bank lending survey reported that the “net tightening in credit standards was the largest reported since the euro area sovereign debt crisis in 2011”, especially noticeable in the corporate sector. Various ECB Governors have pointed to the importance of that survey.
The US economic data was rather mixed. GDP only grew 1% annualised in the first quarter. However, weaker business investment and a massive run down in inventories offset continued strength in consumer spending and robust government expenditure. In particular, Fed hawks must be concerned that a core inflation measure in the GDP report grew almost 5% annualised in Q1, the fastest for a year. Conversely, doves would point to elements of the latest Fed regional survey, its Beige Book. This showed “Conditions in the broad finance sector deteriorated sharply coinciding with recent stress in the banking sector. Small to medium-sized banks reported widespread declines in loan demand across all loan segments. Credit standards tightened noticeably for all loan types, and loan spreads continued to narrow. Lending volumes and loan demand generally declined across consumer and business loan types”.
Official statements also suggested that both central banks would act again. Cleveland Fed President Loretta Mester said the central bank still has more interest rate increases ahead of it. “Demand is still outpacing supply in both product and labour markets. In order to put inflation on a sustained downward trajectory to 2%, I anticipate that monetary policy will need to move somewhat further into restrictive territory this year, with the fed funds rate moving above 5%”. Even if a recession happens, she does not expect it to be deep. In Europe, Dutch central bank governor Klaas Knot said he is “not uncomfortable” with current market expectations of rates topping out at around 3.85% from the 3% currently. Belgian central bank governor Wunsch called for more rate hikes, until wages start weakening. “I would not be surprised if we had to go to 4%”. “We are waiting for wage growth and core inflation to go down, along with headline inflation, before we can arrive at the point we can pause”.
There was little important economic data in the UK, and Huw Pill’s speech about the UK having to be a poorer country caught a lot of adverse headlines but did not advance the argument much about what the MPC will do next. Yes, retail sales were weak in March, down about 3% from a year ago. However, a lot of the decline could be blamed on bad weather just as much as inflation squeezing people’s finances. The Bank will pay closer attention to the UK’s Purchasing Manager PMI index. This rose almost to 54 in April, above analysts’ consensus forecasts, again as service sector strength offset manufacturing weakness. However, a separate CBI survey reported stagnant order books, modest employment expectations and weak pricing power – all music to the ears of dovish members of the MPC. Watch and wait for more data would seem the order of the day.
Although the economic data and central bank comments did not alter the yield curve much between 2 and 10 year bonds, there were sharp changes in shorted dated debt. Yields on US 3 and 6 month bills are 0.25-0.5% higher than a month ago, and this is rippling through into other markets. One problem was renewed concern about US banks. Assets have been leaving First Republic Bank and no one seems to be in a hurry to pick up the pieces. Whether this is another one-off or the start of a worrying domino effect waits to be seen. Of course, policy makers are making positive statements that all is well. Separately, the US House of Representatives passed a budget bill which will not go any further but does put pressure back on the White House in terms of negotiations about the debt ceiling. Economists are still busy measuring cash flows in and out of the Treasury’s books, and estimate that the US Government could run out of money in June or July this year. Technical measures (i.e. US sovereign CDS spreads) continue to deteriorate as investors take out hedges against messy negotiations over the debt ceiling.
As ever, bond markets are trying to decide what is the next major factor. The list of topics to choose from is sadly rather large, and hence their time horizon shifts constantly from shorter to longer term issues.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.06 3.58 3.51
UK 3.83 3.69 3.83
Germany 2.84 2.44 2.45
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