Important decisions announced a long way away
Benchmark gilt yields ended the week higher, but this was less the result of the 14th successive move by the Bank of England and much more to decisions announced in Tokyo, Beijing and New York.
The MPC’s decision to take interest rates to 5.25% was not a surprise, neither was the statement indicating that interest rates could be raised further if there is evidence of persistent price pressures and wage growth remains too high. The good news for the Chancellor is that inflation is forecast to decline to 5% by the end of 2023, and under 2% in 2 years’ time. However, a key assumption from the Bank is that interest rates remain above 5% all during the forecast period. On balance the market thinks another 0.25% move in September is very likely, although November is now 50-50.
Whilst the MPC did day that “it was too early to conclude that the economy was at or very close to a significant turning point”, data continues to suggest that households and businesses are under pressure. July’s BRC shop price index showed ongoing disinflation, albeit partly due to retailers cutting prices on clothing because of the wet and cold weather. A CBI report noted a sharp pullback in retail sales last month, whilst another survey reported footfall dropped between June and July for the first time since 2009. Lastly, manufacturing activity dropped last month at the steepest pace so far this year, according to a business survey from S&P Global. Their economist warned that “the economy is on the glidepath to anaemic growth with industry now at risk of facing a recession.”
Gilt yields react to domestic news but also global issues. Bond yields around the world have come under pressure due to announcements in Tokyo, Beijing and New York. The first was the decision by the Bank of Japan to raise the level at which it will buy government bonds from 0.5% to 1%. As a result, benchmark yields reached their highest since 2015. If domestic bonds are more attractive, so fewer Japanese investors will look overseas for yield opportunities.
Secondly, the economic data from China remains downbeat. For example home sales in July fell the most in a year, adding to concerns about indebted developers, while manufacturing is clearly slowing on the back of weak world trade. At a recent Politburo meeting the party’s rhetoric shifted, with pledges to expand consumption by raising income levels. So far, the actual details have been limited, for example some tax measures to support small businesses and rural households, but the markets are speculating about interest rate cuts by the central bank. Action to boost the world’s second largest economy would not sit easily with efforts in Europe and America to slow down activity.
One piece of US news certainly caught the attention of the media. The ratings agency Fitch downgraded US government debt from AAA to AA+, citing a growing debt burden and poor governance due to repeated political standoffs over the debt ceiling. Whilst none of this is new news to investors, it comes at a time when there is growing recognition of the tsunami of debt issuance fast approaching, even before any promises of fiscal largesse in the run up to the 2024 Presidential election, and against a backdrop of the Federal Reserve actively selling rather than adding to its bond holdings. US budget deficits are already running above 6% of GDP out to 2025; spending on debt interest is already running at $1 trillion a year. The weighted average interest rate for total outstanding Federal debt was 2.8% at the end of June, up from 1.8% a year earlier, and on course to rise another 1% in the coming year if the Fed keeps rates higher for longer.
US markets continue to assume that the Federal Reserve will keep policy on hold into the autumn. Inflation remains on a downward path, if slowly. One measure of core consumer inflation
dipped below 4% on an annualized basis for the first time since the first quarter of 2021. However, employment costs at still growing at 4% a year, well above what the Fed would like to see, and so far labour market surveys suggest little slowdown in job hiring. Looking ahead, Fed Governors will keep a close eye on the banking sector, which has started to shrink loan books modestly in recent weeks. The latest senior loan officer survey showed tighter lending standards and slowing demand for commercial borrowing. However, the conditions do not yet appear to be falling into place for the Fed to cut interest rates sharply into 2024. Although ISM business surveys suggest continued weakness in the manufacturing sector, the more important services sector continues to hold up. Most economists are shifting their forecasts away from an actual recession to suggest moderate 1-2% economic growth – the fabled soft landing – in coming months.
The markets view another interest rate hike by the ECB in September as 50-50. On the plus side, headline inflation has slowed further to 5.3% in July. Economists generally expect it will slide towards 3% by the end of the year as the contribution from energy prices turns negative while food inflation moderates. Admittedly, core inflation remains rather sticky about 5.5%, on the back of nominal wage growth for newly advertised positions still running at 4-5% a year. This reflects a record low Eurozone unemployment rate declining to 6.4% in June. The economy looks weak but again no recession is expected. Economists are forecasting that the Eurozone grows about 0.5% in 2023 and 1.25% in 2024, restrained by manufacturing and exports but held up by consumption and services. A growing headwind is the state of the banking sector; the ECB’s latest bank lending survey confirmed that banks are tightening credit standards on housing and corporate loans, but not yet excessively.
Where next for gilt yields? The MPC can stop raising interest rates if it sees inflation slowing towards its target, on the back of diminished wage pressures, but it will also not want to see further major surprises from policy makers in far flung cities.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.89 4.29 4.17
UK 4.98 4.48 4.49
Germany 3.14 2.59 2.55
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