Calm in the August holidays, but look out for autumn storms
If we look at the economic data, it is quite understandable why central bankers have been indicating that little more monetary tightening is needed, even just a few more moves in the UK. However, the forecasting ability of policy makers and economists is not high at present, inflation and economic growth could prove stronger than expected into 2024, whilst decisions about central bank bond sales could upset markets when government borrowing is so high.
The Federal Reserve decided to raise rates this week by 0.25%, as widely expected; the accompanying statement in theory left the door open to move again in September. As far as the doves are concerned, further tightening of monetary policy would heighten the risk of recession and financial instability. This week, they would point to the senior bank loan officer survey where there was more evidence of difficult credit conditions. Conversely, the hawks on the Fed will point to an improvement in consumer sentiment which could pave the way for stronger retail spending ahead. One measure of household confidence rose to its highest level since July 2021, supported by evidence of that jobs are plentiful. The latest manufacturing and services sector PMI surveys, at 49 and 52 respectively, suggest little change in direction for an economy expanding about 2.0-2.5% a year. The Fed remains data dependent.
When ECB officials gathered for their July meeting there was little doubt that the deposit rate would also be lifted by 0.25% to 3.75%. In her press conference afterwards, Christine Lagarde was keen to leave all options open. On balance, no action in September’s meeting would be understandable. The latest business surveys were more downbeat; the overall PMI index dropped from 49.9 to 48.9, largely driven by more evidence of weakness in German and French manufacturing. This chimes with Germany’s most prominent Ifo leading indicator which dropped for the third consecutive month. Last but not least, Euro area bank lending to businesses has stalled since last autumn, whilst the ECB’s latest credit survey showed falls in loan demand from households and a tightening of lenders’ credit criteria. Such data helps explain why financial markets are pricing in rate cuts from spring 2024.
Against that background, the expectation is that the Bank of England will raise interest rates again next week, but only from 5.0% to 5.25%%. Expectations for Bank Rate at year end have dropped from about 6.25% to 5.75-6.0%. The MPC will be generally pleased with the direction of economic data. Admittedly retail sales were stronger than expected in June; for the whole of the second quarter, sales volumes were up about 2%. The fading hit from higher energy bills appears to have come to the rescue, whilst wages are still growing 5% year on year, stronger than the Bank would like to see. However, business surveys and tight credit conditions still point to an economy that looks set to grow well below potential. Manufacturing activity was at its lowest for over three years, and services at its lowest in six months. Consumer confidence fell for the first time in six months, as more people became concerned about the climate emergency, soaring food prices, and business warnings of weak employment growth. The EY Item Club, which uses the same forecasting model as the Treasury, has lowered its forecast for UK economic growth to only 0.8% in 2024. “The Bank of England’s hawkishness is going to condemn the economy to sluggish growth, even though inflation is probably going to come down quickly of its own accord.”
Of course, dovish central banks could be surprised on various fronts. A possible rise in food inflation, driven by climate shocks and the Russia-Ukraine war, would be unfortunately timed. The world economy is growing relatively steadily at present, and economists are moderately upgrading their forecasts. The IMF’s World Economic Outlook now projects global growth will be 3% this year, about 0.25% higher than they anticipated in April. In this respect policy decisions in China could be rather important. This week’s Politburo’s meeting indicated that China would take additional measures to boost the economy in the second half of 2023, although so far details are lacking.
Bond markets could also react to other issues, such as the pressures from high levels of government debt. The US fiscal deficit has reached 8.6% of GDP on a 12-month average basis, not far from the level it reached during the depths of the financial crisis, double the size of a year ago. In this context important discussions are taking place about QT, or central bank sales of the massive holdings of government bonds which they bought in recent years. The Fed, ECB and Bank of England each own about one third of their country’s national debt. Dave Ramsden, the Bank of England’s deputy governor, announced that it would quicken the pace of QT from September. How this chimes with the UK government’s worsening debt interest position is a moot point. As widely reported, the UK is on course to spend £110 billion on debt interest this year, amounting to 10% of government revenue, the highest of any developed country. This partly reflects much higher interest rates but also the fact that one quarter of government debt is inflation linked.
Bond yields were little changed this week, as central bankers had put a lot of effort into controlling expectations. Markets may be rather calm over the August holidays, but the autumn could bring storms from all points of the compass.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.94 4.23 3.98
UK 5.07 4.47 4.35
Germany 3.236 2.60 2.48
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