The Bank of England (BoE) is in a bind. It anticipates that inflation is going to fall quickly during the rest of the year, but its credibility is being tested.
As recently as February it was expecting Consumer Price Index (CPI) annual inflation for March to be 9.2%; in fact, it came out almost 1% higher at 10.1%. Yes, this was lower than the previous month’s 10.4% but the underlying picture was worrying. Core inflation failed to fall at all, and food price inflation hit a 45-year high.
It is domestically generated inflation that is now the main concern. Looking at the earnings data released last week, wages are growing quickly – less than headline inflation but much higher than the BoE wants. The trend in wages is more marked in the UK than in either the euro area or US. Confederation of British Industry surveys show that UK companies are finding it difficult to get workers; the labour force shrunk during Covid and has not recovered. Perhaps this explains the paradox of a 12-month high in UK consumer confidence during a cost of living crisis.
So, what does the BoE do? The argument that interest rates are a blunt weapon for globally generated inflation may be valid but the situation is changing. It is the domestic economy which is the issue. There are two approaches that could be pursued. First, stick to the view that monetary policy works with unpredictable lags and that the economy will cool during the second half of 2023. Coupled with the fall in energy prices, the CPI reading will come down. Basically, hold your nerve.
The problem is that investors are losing confidence in such messaging. And this is the dilemma. Even if the BoE has conviction in its own views on how the economy is evolving, that is not the only factor. Lose confidence of markets and the consequences can be painful – sound familiar?
So, if the BoE fails to tighten in May, I expect to see a sell-off in sterling (giving a further inflation impulse), and higher long-term rates. The second option is to tighten again. If we look at what is priced into markets, we can see that there has been a material shift in bank rate expectations. During the mini banking crisis markets were anticipating year end UK interest rates at 4% or below. Today it is between 4.75% and 5%. It looks like the BoE has no choice – even if it feels that past tightening has not yet fully kicked in. I see the second option as more likely to prevail.
The question is: at what level of bank rate does the domestic economy slow down? I think that anything around 5% will be enough to cool the labour market. Indeed, given how I see the global economy developing I would see such an outcome as giving rise to a ‘normal’, as opposed to technical recession.
In big picture terms there are two contrasting scenarios currently doing the rounds. The first, as outlined by the International Monetary Fund (IMF) recently, is a return to an environment of ultra-low interest rates. It’s about demographics. The IMF believes that low growth in the working age population, combined with poor productivity growth and a savings glut will keep real interest rates low. These factors have done just that since the 1990s and that those key drivers simply haven’t gone away. So once policy makers have cracked current inflation, it is back to a low bond yield world.
The alternative view is that things have changed. An ageing profile in Asia and reduced reliance on oil will mean secular dissaving. In addition, there are geopolitical trends which may lead to a new investment boom e.g. onshoring, higher defence requirements, climate change preparation and remediation, infrastructure spending etc. All this investment could soak up excess savings and push up real yields.
Where do I stand? Well, I think we are headed for an economic slowdown, and this will keep real yields low (i.e. more towards the IMF case). However, when looked at through a historical lens, real yields are too low. The problem is investment horizon: for the time being I am becoming more positive on government bonds. As an aside, when economic historians mull over the last 10 years there will be a temptation to outline the great missed opportunity that the UK had – namely to use the abnormally low real yields to reset our growth trajectory. They may also ponder on the wisdom of quantitative easing.
Markets were well behaved last week although there was a trend for higher yields across curves. In the US 10-year yields moved towards 3.6% whilst the German equivalent hovered just below 2.5%. In the UK yields moved up a bit more, with the 10-year yield finishing above 3.75%. Overall, the picture is consistent with further rate hikes from major central banks in May.
Investment grade credit spreads moved tighter and there remains good demand for well rated, medium, and longer dated bonds in the sterling market. There also continues to be rehabilitation in bank and insurance company debt: both senior and subordinated. Looking at lower tier 2 bank debt (below senior but above AT1s) credit spreads went from 2.2% in February up to 3.4% during the height of the mini financial crisis and are now back around 2.6%. Recovery in AT1s has been less pronounced but my bellwether, a recently issued Barclays 9.25% bond, ended the week at a spread of 7.5%, 200bps below its recent wide.
The conundrum of labour markets and their post-Covid evolution continues to vex central banks. My view remains the same: monetary policy will continue to be tightened to cure inflation and this will lead to slowdowns and recessions.
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