Last week was all about interest rate decisions. Strangely, although the Federal Reserve (Fed), Bank of England (BoE) and European Central Bank (ECB) all increased rates by 50bps there was quite a bit of divergence underneath.
In the US, the pace of hikes was slowed and this was taken bullishly. But there was a clear message that getting on top of inflation was a priority, with a signal that the peak would be in the range of 5–5.25%, implying three more hikes of 25bps. The ECB also stepped down its pace but delivered a more hawkish statement, outlining significantly higher inflation expectations; we should be expecting further 50bps moves and a terminal rate above 3%.
The BoE delivered a more mixed message. Whilst the majority supported the 50bps increase to 3.50% there were three dissenters – one arguing for a 75bps move and two favouring no change. The nuance of what was not said is interesting – there was no longer a reference to markets pricing in too many rate hikes. If we look at the UK rates curve, we can see that a peak occurs in Q2 2023 at around 4.50%; as a reference this climbed above 6% in the aftermath of the September mini-budget.
Is the UK picture less bad?
There were mildly encouraging signs that UK inflation is moderating with Consumer Price Index (CPI) coming in at 10.70%. There appears to be positive news in relation to goods inflation, as supply chain bottlenecks ease. Conversely, food and service inflation remained sticky with evidence that higher input costs were working their way into consumer prices. The data also showed a growing ‘wedge’ between Retail Price Index (RPI) and CPI inflation. The former is now over three percentage points higher, with the main driver being the mortgage interest component (in RPI, not in CPI). For choice, the BoE is sounding a bit less bearish on the short-term economic outlook, revising up their near-term Gross Domestic Product (GDP) forecasts and talk of a slight fall in GDP in 2023 Q1. Indeed, Purchasing Managers' Index (PMIs) last week were not that bad, consistent with only modest falls in activity, with both euro area and UK composite PMIs readings moving higher. There is a pattern: improving supply conditions, lower cost pressures and stabilisation in business confidence. Overall, it is clear that the BoE is not as transparent as the Fed and ECB in signalling their near-term interest rate intentions. I think we can expect further UK rate rises and continuing dissent until a clearer picture of the magnitude of the recession becomes apparent. A peak in UK rates at around 4.50% looks a reasonable estimate to me.
Stability is unstable. Is this a contradiction? Not really. It is a phrase associated with Hyman Minsky, a leading US economist of the 20th century. Put simply, the longer things remain the same the more we expect them to continue that way. We become complacent and when things do eventually change, the shock is that much greater.
Listening to a talk by Edward Chancellor (author of 'The Price of Time') last week put this phrase into historical context. To sum up his thesis: history is littered with examples where investors become complacent, where money is cheap and leverage enhances return. He argues that interest rates are a mechanism for pricing time and that without interest it becomes impossible to value investments. Applying his analysis to the present situation is pretty sobering. The re-pricing of the cost of money will invalidate many current approaches. Whilst I am not expecting a financial crash it has to be a growing risk. So recent surveys may be a bit better but don’t be misled – we are in for a tough time.
Euro and UK bond markets more active
Bond markets diverged over the week. US treasury yields were broadly unchanged with the 10-year rate staying around 3.50%. In the euro area and the UK, it was a different story. German 10-year yields rose 20bps, taking the rate to 2.20%. Closer to home, the UK 10-year bond yield ended just below 3.35%, a similar rise to that of Germany. Italy was a big casualty, seeing its 10-year yield hitting 4.30%, a rise of nearly 50bps. Implied inflation also diverged between the UK and US, with it falling in the US and rising here. I think this was more a story about domestic real yields, which had risen recently as the BoE unloaded the bonds bought during the liability-driven investment inspired crisis. As this process comes to an end there are signs that there is demand for sterling index linked bonds. This had the effect of pushing real yields down and implied inflation up. I don’t think we should read too much into this – from an inflation perspective.
Credit spreads probably tightened for choice and within sterling investment grade credit there seems to be a pre-Christmas bid – selling being a bit easier than buying. Overall, credit bid/offer spreads are returning to more normal levels although investors remain wary of real estate and cyclical consumer areas. High yield was broadly unchanged, having rallied hard in recent weeks.
Let’s end on both the sublime and ridiculous. A great World Cup final, dominated by the two best players. A dull first half followed by an exhilarating demonstration by two outstanding teams: well done to both. The ridiculous is the award of a bonus to Avanti for, among other things, its consumer experience April – September 2021 on its West Coast train service. Truly panto season has arrived.
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