The Bank of England (BoE) hiked UK bank rate to 1.75% last week, meeting expectations of a 50bps move. The immediate reaction in the market was to take bond yields lower. Why was this?
Well, it reflected the cautious outlook that accompanied the decision. The UK is now projected to enter recession from the fourth quarter of this year. But given the grim growth outlook, why hike at all? The answer is that the BoE sees increased signs of domestic inflationary pressure, with a particular concern about the tight labour market.
Consumer Price Index (CPI) inflation is now forecast to be just over 13% in Q4 2022, and to remain at very elevated levels throughout much of 2023, before falling to the 2% target by mid- 2024 and then continuing lower. It looks like the BoE envisage tightening a bit less than the market profile for interest rates (3% priced in for mid next year). Apparently, one reason for the higher CPI forecast in Q4 is that businesses are reporting that they can pass on cost increases. Let’s see how long that lasts in the face of recession.
It is one of the great quirks of life that we are conditioned to extrapolate current trends. It’s because we find it really difficult to assess unlimited information, with the easiest course to assume continuation. Back in 2020 when we were being prepared for negative interest rates, I wonder how many of us contemplated Retail Price Index (RPI) inflation breaching 15% in 2022. And this is the great worry: that 30 years of disinflation will be unwound by changing expectations of future inflation. Ultimately central banks will need to make a choice: recession or inflation; current thinking is that inflation would be the greater risk.
Now for QT
There was also an update from the BoE on active Quantitative Tightening (QT). The bond reduction programme is due to begin in September, at a pace of £10bn a quarter and is expected to reduce the stock of gilts held by £80bn over 12 months (including maturing bonds). The BoE emphasised that Bank Rate was its prime policy tool for monetary policy adjustment and that sales would be conducted so as not to disrupt the functioning of financial markets. Good luck. I still cannot fathom why Quantitative Easing (QE) was not reversed earlier. After all, 10-year yields were below 0.5% in early 2021 when economists were predicting a strong bounce in activity. What was the BoE trying to achieve? Now, bonds will be sold into a less receptive market.
An early, and perhaps unreliable straw in the wind, was sighted last week. Halifax recorded that UK house prices showed a decline in July, the first drop in over a year. Nationally, house prices are still 11.8% higher over 12 months but I cannot see present values being maintained as recession bites and mortgage rates rise. The robust labour market will help but real estate has still to adjust to the change in real yields that has impacted financial assets over the last six months.
The Federal Reserve still on course for more hikes
In the US, last Friday’s employment data was unambiguously strong. Average earnings came in above 5%, the unemployment rate nudged down to 3.5% and job creation was significantly above expectation, accompanied by upward revision to last month’s payrolls. In short, nothing to stop another 75bps rate hike next month. Unless this week’s CPI shows some moderation, the Federal Reserve will deliver another big ratchet up in rates.
Government bond yields higher, credit tighter
So how did bond markets do last week? Two-year US treasury yields shot up on the employment data, ending at 3.2%, 30bps higher on the week. Yields on 10-year and 30-year bonds also rose, but by a more muted 15bps. The much talked about US yield curve inversion became more pronounced with ‘2-10’ differential increasing to 40bps.
The picture in the UK was similar with two-year yields approaching 2% and the 10-year yield finishing above that level. Perhaps a surprising feature in sterling markets was the performance of real yields. They were broadly unchanged at longer maturities with a consequent rise in implied inflation. So, just as the BoE is warning of recession implied inflation has taken a jump higher in recent weeks. A difficult one to fathom.
Credit markets were in rebound mood last week. High yield markets rallied strongly with spreads now more than 100bps tighter than the early July wides. Issuance remains very subdued and although there has been a rebound in real estate debt confidence remains fragile. In investment grade markets there was a modest move tighter although liquidity remains poor. There was a debut bond issue from Meta, the social network company, with $10bn being raised in several ‘A’ rated tranches.
Looking at the global picture the outlook looks challenging. The Ukraine war carries on, China / US relations are deteriorating, food price inflation is a problem in many countries and investors are expecting recessions in many major economies. Against this background equities finished higher and materially above the lows of mid-June. Equity investors are seeing sunny uplands; bond investors are worried about the journey there.
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