Three central banks with problems

This week has brought into focus the fact that the world’s major central banks still have an inflation problem, even though two of them have been hiking interest rates for over a year. Is the global economy immune to these rate hikes? Does the consumer have pots of money stored for these types of economic conditions? And why are stock markets so stable when bond markets are highly volatile and jittery? These are the questions that are dominating financial markets right now. While we don’t have all the answers, we can help to provide some valuable context, which may help you to make better trading decisions in these highly unusual times.

The BOE: another panic in the Gilt market

UK bond yields have fallen slightly at the end of the week; however, UK 2-year bond yields are still higher by nearly 60 basis points this week. This increases the cost of capital for mortgage holders trying to refinance and for business owners that rely on credit lines. The driver was higher than expected inflation. Although headline inflation fell, it did not fall by as much as expected, added to this, core inflation in the UK rose to 6.8% YoY, up from 6.2% in March. The fear is that inflation is becoming entrenched at a high level, which makes a mockery of the BOE’s 2% inflation target. A 6.8% reading of core inflation is the highest level since 1992. The inflation data spooked the markets, and at the time of writing the market now expects the UK terminal rate to rise to 5.51% in December 2023, this is 1% higher than last week’s expectations for the terminal rate. Added to this, the market now expects only 16 basis points of rate cuts between December 2023 and May 2024. This is a significant upgrade to UK rate expectations, and one that will have economic consequences for many. Already, the Chancellor has backed more interest rate increases to curb soaring inflation, saying that the only path to sustainable growth is to bring inflation under control. He even said that he would support rate increases if they triggered a recession, which is a big statement for a chancellor to make. Currently Bloomberg’s recession prediction model has a near 60% probability of a UK recession in the next 12 months. This had been as high as 90% after Liz Truss’s budget last Autumn, however, it is still uncomfortably high.

Interestingly, the FTSE 100 is higher on Friday, although it has had a torrid week, with the index down 1.5%. We have mentioned that 2023 has all been about the AI trade and the phoenix-like rising from the ashes of tech stocks. In comparison to the FTSE 100, the Nasdaq is up nearly 20% so far this year. GBP is also stabilising after recent losses, and GBPUSD is hovering around the $1.2350 mark. If we continue to see downside volatility in the bond market and UK gilt yields surge, then we could see another collapse in the pound. Back in October, a prospect of a pensions crisis caused GBP to fall back towards parity with the USD. Thus, if bonds yields continue to rise next week expect two things: 1, more pound weakness and 2, BOE intervention to calm longer term Gilt yields.

The Fed: better economic data reduces chance of a pause

US economic data continues to surprise on the upside. Core PCE rose in April, rising to 4.7% on an annualised basis, up from 4.6% in March. Durable goods orders also rose by 1.1%, although when you strip out autos and defence, sales fell on the month. However, consumers need to feel confident to buy a car in the current climate, which is also a sign of underlying strength in the US economy. Personal spending rose in April, up 0.8%, while personal income also rose by 0.4% on the month. The US economic surprise index has turned higher, and we will wait to see at the end of this week if consumer confidence also turns higher as we wait for the second reading of the University of Michigan consumer sentiment survey for May. The market has seen a surge in bets that the Fed will not pause rates next month, and instead will hike. The probability of a rate hike to 5.25-5.5% is now 58%, with a 42% chance of a pause. This is a massive shift in expectations. Interestingly, this has not stalled gains in tech, as big tech giants and chip makers seem immune to the prospect of higher interest rates reducing their future cash flows. Tech is proving itself to be a defensive sector as we move through 2023. The USD continues its march higher and is set to end the week up 0.7% on a broad basis. We expect further gains for the USD as we lead up to the Fed meeting in June, and we think that it will perform strongly in the coming weeks against other G10 crosses.

The ECB: still in the thick of rate hikes

Lastly, the ECB has stuck to its hawkish mantra as it plays catch up with the Fed and the BOE. This was reinforced at the end of this week, as the ECB’s chief economist, Philip Lane, said that Eurozone wages are rising in a “moderate way” even though recent pay negotiations in some member states have seen wage increases of 5% or more. Lane said that there could be more in the way of wage growth later this year, but that wages would not rise faster than inflation. This is about as hawkish as a central bank economist is likely to get, and we expect the ECB to hike rates. The question now is, will they hike by 50 bps in June or by 25bps. A 50 bp hike could see reversal in the fortunes of EUR/USD, which is down more than 2% so far this month.