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The bond market is the elder statesman of the financial world. The stock market, the foreign exchange market – and even the property market – are skittish, fickle creatures, prone to sudden movement for little apparent reason. The bond market, on the other hand, is supposed to be more measured, or at least it always used to be until it was distorted by QE.
Until last week, as Fed officials discussed reversing QE, an observer of ever-falling bond yields could reasonably have concluded either that the sale back to the market of the Fed’s USD 2.5 trillion of Treasuries (plus USD 1.8 trillion of mortgage-related securities) was going to go swimmingly – or that a recession was imminent.
Meanwhile, at the beginning of last week, 10-year German Bund yields were trading at 0.25%. Then, last Tuesday, Mario Draghi dropped the bombshell that not only has the ECB been successful in avoiding a deflationary spiral, but also the ECB now judges deflationary forces to have been replaced by inflationary ones. This caused a sell-off in the bond markets that led to an almost doubling of the 10-year Bund yield to 0.47% by Friday. Once ECB officials realised the impact of Draghi’s statement on the bond markets, there was a swift denial that their boss had quite meant what he had said.
However, the damage was done. In any case, Draghi’s comments were mirrored last week by other central bankers in the US, UK and elsewhere, to the effect that the end of ultra-loose monetary policy is upon us. Indeed, the comments smacked of co-ordination on the part of the central banks and this makes perfect sense. Investors are still desperate for yield and small changes in interest rate differentials have large effects on exchange rates. Any central bank that now lagged its contemporaries would run the risk of its currency underperforming – with potentially inflationary consequences. The Fed led on rate hikes and was the first central bank to mention the reversal of QE. The effect of this, helped by initial euphoria over Trump, was considerable dollar strength. However, as the ECB and BoE have started to play catch-up with the Fed, dollar strength has been unwinding. GBP/USD and EUR/USD traded this morning as high as 1.3023 and 1.1427 respectively, both boosted by the growing likelihood of rate rises, whatever ongoing differences of opinion exist on the MPC.
The point is that the rise in bond yields seen in the UK, the eurozone and the US last week should not be dismissed as ‘noise’, as one might deem a random 5% or 10% move in the FTSE 100 or even in the pound. The fact that so many central bankers were alluding to the end of highly accommodative monetary policy last week shows something more organised is afoot. Indeed, Mark Carney seemed so keen to trot out some hawkish comments, to appear ‘on message’ with his fellow central bank chiefs, that he apparently forgot to inform his Deputy Governors. Among them is Sir Jon Cunliffe, who stated last week that he prefers to await developments on inflation and see whether increases in business investments and exports can offset a consumer slowdown. I’m with Carney on this one: inflation looks set to rise further while, unless the UK economy has managed to perform a radical metamorphosis, there is precious little evidence that anything other than monetary easing can substantially offset a consumer slowdown.
Inflation is, of course, a central banker’s raison d’être. While, at 2.9%, it is roaring away above target in the UK, this is on account of the pound’s depreciation a year ago. The inflationary effects of the weaker pound will at some point moderate, although it is highly unlikely that even a year on the full effects of the pound’s fall have worked their way into the general price level. Hence, it will get worse before it gets better. As long as wages do not start rising in sympathy with inflation, a vicious cycle may be avoided.
Unfortunately, it looks as though the government’s self-inflicted weak parliamentary position is set to throw a spanner in the works as public sector workers, starting with the nurses, line up for pay rises. With even ‘big beasts’ like Boris Johnson joining the revolt and calling for a removal of the 1% public sector pay cap, it appears fiscal rectitude is set to go the way of all flesh, hot on the heels of Theresa May’s majority and authority. Furthermore, it is not just public sector workers who are feeling the pinch. The UK household savings ratio fell in Q1 2017 to just 1.7% - the lowest since records began in 1963. This could be explained by households feeling very secure in employment and therefore not needing to save. It is more likely that they are not saving because they are having to spend a higher proportion of their net income to make ends meet.
This bodes ill for inflation, as there will doubtless be plenty of calls for some eye-wateringly large public sector pay rises to make up for the recent austerity – though how government borrowing of £1 billion per week can be called ‘austerity’ is a moot point. Indeed, it is worryingly reminiscent of the seventies, when weak governments, starting with Heath’s Conservatives – who were deposed by the miners in 1974 – and Wilson/Callaghan, the latter of whom was forced into a pact with the Liberals to cling to power, faced the nightmare of trying to control inflation against the backdrop of a highly unionised labour force. The results of this very difficult period were the Winter of Discontent of 1978-79 and Thatcher’s election in 1979. Although the private sector is now virtually de-unionised, and overall union membership has more than halved since the 1979 peak of 13.2 million, the public sector remains heavily unionised. Perhaps it would be better to undo the purse-strings to avoid damaging strikes; but that is how it always looks at first. It is interesting that Brexiteers Gove and Johnson support public sector pay rises. This makes sense as, for the sake of their careers, austerity must not be associated with Brexit.
The ECB’s job is a little easier than the MPC’s. We learned last week that eurozone inflation fell from 1.4% in the year to May to 1.3% in June. Core inflation rose from 0.9% to 1.1%, but Draghi looks to have considerably more time on his hands than Carney before he needs to raise rates. Indeed, he managed to achieve considerable monetary tightening last week simply by giving one speech.
The MPC’s job was made even more difficult this morning with the release of substantially weaker-than-expected manufacturing PMI data. The index came in at 54.3 in June, below the forecast of 56.3 and down from May’s 56.7, taking half a cent off GBP/USD. The construction and services PMIs are out tomorrow and Wednesday and are expected to be 55.0 and 53.5 respectively. If these also show signs of weakness, the debate over rate rises on the MPC will become intense. Meanwhile, eurozone manufacturing PMI for June came in this morning at 57.4, a strong number, up from May’s 57.0.
The most important figure of the week will be the US non-farm payroll number on Friday – expected at +177k for June after May’s disappointing +138k (though that did not stop the Fed raising rates). By the time of the non-farms, we shall have gained more insight into the Fed’s thoughts following the release of the minutes of the last FOMC meeting on Wednesday.
All views expressed here are the author’s own and are based on information and data available at the time of writing.
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