JP’s Journal: The waiting game

Last week was a waiting week. The focus was on the US Federal Reserve and whether we are about to see a pause in the rate hike cycle. We will soon know.

Markets are positioned for rates to stay on hold. Based upon present pricing there is only a small chance of a move up and data last week gave no hint of an acceleration in activity. Within major economies there is a clear divide: services remain robust but manufacturing is coming under pressure. This is reflected in the relative weakness of the more ‘manufacturing’ orientated economies such as Germany. Typically, services account for account for 70% or more of GDP in most major economies and although the latest survey data in the US indicated slowdown potential in service activity, the picture remains pretty consistent: Purchasing Managers’ Index (PMI) for the US, UK and eurozone are all comfortably above the 50, an indicator of expansion rather than contraction. The message is the same in China where the service sector is sustaining its post-Covid rebound.

Conversely, manufacturing sectors are struggling. Manufacturing PMIs in the US, eurozone and UK were lower last month and are consistent with a contraction in manufacturing output. Overall, I think this mixed picture reflects the Covid legacy. Manufacturing was ramped up in the period and we are now seeing some return to trend. Similarly, the strong service activity reflects the ending of lockdown and consumers’ desire to get back to normal. This has been helped by the build-up of savings during the last few years, thereby enabling spending to continue at a more robust rate than I expected.

As my colleague Trevor Greetham has pointed out, this is no normal economic cycle. And this has made the job of central bankers much more difficult. This is not to underplay some of the mistakes that were made but it has been difficult to judge the extent to which demand needs to be dampened to bring inflation down. I still think that the lagged impact of monetary policy and the wider squeeze on household incomes will have an impact greater than is the current consensus. But I have been saying that for a while and consumers remain resilient.

Over the week, US treasury yields drifted marginally higher, ending around 3.75% in the 10-year area – a modest increase on the week but still 30bps higher than a month ago. In Germany, rates also hardened a bit and although higher on a month, the increase has been more muted than in the US. In the UK, developments more closely resembled the US outturn, where 10-year yields were up a bit over the week but are 50bps higher over a month.

Credit markets were a bit more interesting. Investment grade credit spreads continued to defy the bears with spreads tighter on the week. A milestone was reached last week in the UK with the Bank of England completing its sale of corporate bonds acquired in recent years. The unwinding process has been conducted pretty well – ahead of schedule and having no discernible impact on credit spreads. Elsewhere, high yield risk premia also moved lower and are now about 50bps lower over the last four weeks.

This week will give a better indication of central bank thinking, given the importance of US monetary policy to the global economy. Expect a pause – not necessarily a halt.

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