It was the week of interest rate moves. But with a twist: the US Federal Reserve (Fed) went hard with a 75bps hike, while the Bank of England (BoE) increased rates from 1% to 1.25%.
In the eurozone, the European Central Bank (ECB) set the scene for a quick tightening of policy.
Government bond markets, however, were not at the centre of the story. Yes, yields moved higher, but mostly before the rate hikes. The focus in the latter part of the week was on the global slowdown. This was reflected in risk assets – both equity and corporate bonds. Just looking at the equity numbers year to date is sobering: the S&P 500 -23%, NASDAQ -31%, Euro 50 -26% and FTSE All-Share -17%. In Asia, the Japanese equity market has mirrored these falls; while Chinese shares have fared slightly better, they are still down double digits.
Corporate bonds took a step down as well. In high yield, spreads were wider by 60bps at the index level, the biggest widening this year and back to the levels of mid-2020. In investment grade, there was also a meaningful deterioration in sentiment; sterling non-gilt spreads moved to a YTD high of 152bps, the widest level since Brexit (excluding the initial Covid-driven spike in March-May 2020).
Playing catch-up, but risking overkill
The combination of monetary policy tightening, rising prices and global slowdown is not a pretty mix. The Fed’s response focused on concerns that inflation expectations were becoming ingrained. Its median forecast is now for a 3.5% Fed Funds rate at year end; this is 75bps higher than expectations just four weeks ago, with a peak in the 3.5%-4% range. The pain will be felt through higher unemployment, which is now projected to be above 4% in 2024. Is a US soft landing possible? Absolutely, but with so many economic imbalances the Fed is charting a pretty narrow path.
The BoE will be regretting the hesitancy of last year and its ongoing Quantitative Easing (QE) stance. Last week’s 25bps hike was expected, although there were three votes for a 50bps move. There was an increased focus on domestic inflation, with reference to the tight labour market and firms’ pricing strategies. The BoE now expects Consumer Price Index (CPI) inflation to rise above 11% in October and noted that higher inflation was becoming more widespread in the CPI basket. Unlike the Fed, however, the tone on further rate hikes was a lot more mixed. Interestingly, a previous Governor, writing in The Spectator last week, remarked that the latest CPI data caused his eyebrows to rise sharply. Is this code for saying the present decision makers are being much too cautious?
Real-world effects of wealth destruction
The scale of the sell-off in bond markets is clear. Looking at a list of UK government bonds issued in the last two years is illuminating: 2031 gilt priced at £87, 2035 at £77, 2046 at £68, 2050 at £60 and 2061 at £50. All were issued around £100.
What we are seeing is a rise in real yields, price / earnings (PE) ratio contraction, heightened risk premia in credit and growing risk aversion. And the moves we have seen will have real economic consequences. The wealth destruction, in recent months, through equity and bond moves has been significant. Add to this the speculative positions taken in cryptocurrencies and the evaporating gains in this area and the soft-landing scenario looks even more challenging.
In a fairly small field Andy Haldane, ex-Chief Economist at the BoE, has emerged with some credit for his stance on earlier rate hikes. He is presently focused on the Government’s ‘levelling up’ agenda. One figure shows the scale of the challenge: it is estimated that the UK will be short of 186,000 skilled engineers by 2026 and that presently half of engineering firms are finding it difficult to recruit. I am a great believer in tertiary education, but the UK has become fixated with university education to the detriment of vocational training. Unless we address the gap in vocational training and ascribe suitable status to it, it is difficult to see how levelling up will work.
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