A swift about turn
Central bankers are still trying to convince investors that policy makers are in watch and wait mode. However, bond markets are clearly pricing in future rate cuts. The benchmark US 10 year yield has fallen from its 5% peak just two weeks ago to 4.65% at the time of writing.
As expected, the Federal Reserve left interest rates unchanged at this week’s meeting. It tried to sound hawkish; to quote Jerome Powell “A few months of good data are only the beginning of what it will take to build confidence that inflation is moving down sustainably toward our goal. The process of getting inflation sustainably down to 2% has a long way to go”. The statement also made it clear that the Fed is willing to move again if progress on inflation stalls.
However, three events encouraged a noticeable pull back in bond yields. On balance Powell’s comments were interpreted as more dovish than expected, especially his references to the risks of over-tightening, reflecting the impact of higher borrowing costs on key areas such as housing. The Fed does produce a measure of financial conditions. Provisional analysis suggests that the current level of monetary policy could take close to 1% off baseline GDP growth in the year ahead.
A second factor was the weakness in several major economic indicators. The manufacturing sector ISM survey eased from 49 to 47 in October. This chimed with the latest ADP and JOLTS labour market surveys which suggest that the official employment data at the end of the week should not trouble the Fed. Early indicators show consumer spending got off to a much slower start in Q4 than the strength seen in Q3. Although employment costs were strong in Q3, companies showed they could boost the productivity of their workforce so that overall costs were contained.
The third factor affecting the bond market was the latest announcement from the US Treasury about future bond issuance. This will still be massive, but again smaller than had been feared, and more of a focus on shorter dated than longer dated bonds.
The Bank of England joined the Fed in leaving rates unchanged, giving time for higher borrowing costs to ripple through the economy. Continued weakness in the PMI manufacturing survey supported the view that the economy will only grow modestly in coming months. Indeed the MPC warned that it expects zero GDP growth in the UK through 2024 and a 50% chance of recession; however, lower interest rates are still not on the agenda given sticky inflation. Although ahead of the meeting investors were pricing at least two 0.25% rate by the end of 2024, Andrew Bailey argued that it is too early to talking about cuts, while the statement emphasised rates need to be restrictive for “an extended period of time”.
The economy is in a weak state. The CBI reported a deterioration in retail sales this month, with businesses expecting further weakness in demand, while the UK’s BRC shop price index registered further falls in pricing power. Broad money supply growth is now negative, approaching the depths seen during the bank deleveraging experience of 2012. The number of company insolvencies in the third quarter of 2023 was 10% than the same period last year.
Higher borrowing costs will affect the economy for some time to come. The Bank forecasts mortgage debt-servicing costs will rise from 5.5% of post-tax income of all households in 2022 to 8% by 2026. The housing market and consumer confidence are already reacting to these pressures. Zoopla forecasts that home sales will decline by a quarter this year, while the Royal Institute of Chartered Surveyors reported a fall in construction activity in Q3.
The Bank of England will pay close attention to the weak state of its closest neighbours in the European economy. Eurozone GDP showed another small fall in Q3, led by a noticeable fall back in consumer spending in Germany as unemployment reached its highest since mid 2021. A flat Economic Sentiment Indicator in October suggested little improvement in EU activity into Q4. Consumer price trends are creeping towards the ECB’s target; Eurozone October CPI slowed to 2.9% y/y, its slowest since July 2021. With Euro-area financial conditions their tightest since 2009, according to Goldman Sachs analysis, the market does not see any more rate increases in this cycle; indeed it has moved towards pricing in a full 1% of rate cuts by the ECB in the next 12-18 months.
All in all, policymakers are waiting to assess the health of the economy and the path of inflation before potentially making another move. However, bond markets have decided that enough has been done. Current bond yields are seen as an attractive entry point by many investors.
Bond yields at the time of writing
% 10 year Weekly Move
USA 4.67 -0.18%
UK 4.39 -0.23%
Germany 2.70 -0.15%
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