When America sneezes, the world catches a cold
US bond yields set the long-term price of money, or the “risk-free rate”, for much of the world. Upward pressures on US interest rates, combined with higher oil prices, have rippled through global bond markets, even where economic data has been on the weak side. More investors are accepting the view that interest rates need to be ‘higher for longer’.
Financial markets faced 11 central banker meetings over the past fortnight. Although interest rates were kept on hold in most countries, notably in the UK, the key message from policy makers was that interest rates need to remain higher for longer in order to bring inflation down in a sustainable manner. Starting with the USA, Neel Kashkari suggested there was a 60% chance that the Fed will raise rates one further time and then hold them steady “long enough to bring inflation back to target in a reasonable period of time”. “The policy tightening we would soon achieve would be enough to finish the job” and deliver “the proverbial soft landing that we are hoping to achieve”. He said there was a 40% chance though that the Fed would need to raise rates “meaningfully” further to beat inflation.
The benchmark 10 year US yield has moved up above 4.6%, taking US mortgage rates above 7.5%. Interest rate cuts are still expected in 2024 and 2025, but only taking the official rate down to 4.3%. Alongside Fed rhetoric, two other factors driving bond yields higher have been economic data and the oil price. Despite some weakness in business surveys, hard data such as factory orders still suggest that the US economy could grow as robustly as 3% in the third quarter after achieving 2% across the first half of the year. Additionally, oil prices look on course for $100 per barrel, as buoyant demand meets limited OPEC supply. Hence consensus forecasts for headline inflation in the USA have been steadily taken up from 2.5% towards 2.75% for 2024.
European bond yields have been dragged higher in this environment – the benchmark German yield has reached its highest level since 2011. This is despite the rhetoric from ECB Governors and further weak economic data. As Christine Lagarde said “We consider that our policy rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to our target”. Other ECB speakers such as Madis Muller and Luis de Guindos similarly accept that current levels of interest rates are probably sufficient to return inflation to the 2% target, reducing chances of further rate increases.
Indeed some Governors see inflation returning to 2% relatively soon in 2024. One reason for this view is the poor state of many parts of the EU economy. Five German institutes have predicted that German GDP will contract by 0.6% in 2023. The forecast for economic growth in 2024 was revised down from 1.5% to 1.3. Italy similarly cut its growth forecast for this year to 0.8% from 1%, and for next year to 1.2% from 1.5%, blaming restrictive monetary policy and the war in Ukraine. Tighter monetary policy is feeding through into weaker demand for loans. Eurozone M3 money supply fell 1.3% in the year to August, the largest decline since records began.
UK gilt yields were similarly dragged up by about 0.2% over the past week. Although inflation data came in a little better than expected for August – the headline rate eased to 6.7% a year – economists have also boosted their inflation forecasts for 2024, on the back of higher energy costs, despite lowering their growth estimates, with the latest CBI high street survey continuing to show the cost of living pressures on households.
Global bond markets could experience greater volatility in coming weeks and months. It is eminently possible that Congress will enter the deep dark pit of funding resolutions, debt ceiling debacles, a lockdown of the US government, all amidst warnings from credit rating agencies. Striking auto workers, a weaker housing market, and the resumption of student loan payments could have serious effects on the US economy into Q4. The US dollar continues its relentless grind higher, buoyed by the repricing of long-term interest rates, higher oil prices, and concerns over the direction of travel for both the European and Chinese economies. Historically such dollar appreciation has been associated with some form of financial crisis, encouraging investors to rush back into safe haven assets. How much will the rest of the world suffer a cold, flu or a more serious illness before year end?
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 5.01 4.68 4.60
UK 5.04 4.68 4.59
Germany 3.29 2.90 2.96
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