It has been a busy fortnight with markets getting to grips with US inflation failing to ease as fast as expected, with consequences for rates, and in turn, equity and bond markets
Asian markets have been calmer after notable recent volatility in Hong Kong and Chinese indices; the week-long holiday in China for Lunar New Year has come at a good time to allow investors to draw breath. Bond yields have moved higher across western markets but the momentum in US equities, which has seen the S&P 500 make fresh record highs and move higher in 14 of the past 15 weeks, has remained intact, after a wobble earlier this week.
It has been a busy week for UK data, with inflation, employment and growth numbers published. The inflation data was better than expected, with CPI unchanged at 4% year on year in January, against expectations of an increase to 4.2% on the back of higher petrol and diesel prices and the 5% increase in the Ofgem energy price cap. Core inflation, which excludes food and energy, was also unchanged at 5.15%, but services inflation, which is closely watched by the Bank of England, edged higher to 6.5%. PPI numbers pointed to disinflationary momentum in goods prices. Output PPI was down 0.6% year on year, having peaked at 19.7% year on year in July 2022.
The unemployment rate in the UK fell to 3.8% in December versus 4.2% previously and 4% expected. Wage growth eased less than expected, to 5.8% in the 3 months to end December, down from 6.7% in three months to end November. The UK was confirmed to be in technical recession in the second half of 2023 after GDP data for Q4 showed a decline of 0.4%. This follows a contraction of 0.1% in Q3. In 2023, the economy grew by just 0.1%, compared to 0.5% in the eurozone and 2.5% in the US.
Taking population growth into account, output per head shrank by 0.7%. The lacklustre pace of UK growth is not new news; indeed, the UK has barely grown at all over the past two years. However, the “R word” remains politically sensitive, not least in what is likely to be an election year. The fact that this recession appears to be a shallow one, despite the repercussions from Brexit, the pandemic, the fallout from the worst energy shock since the 1970s and a very rapid end to over a decade of ultra-low interest rates is in reality not a bad outcome. However, it offers little comfort to a government so far behind in the opinion polls. The two by-election results last night, which saw significant swings to Labour and the Conservatives losing two seats which previously had large majorities points to the Conservatives having a mountain to climb to secure re-election.
The messaging from the Bank of England was somewhat mixed, highlighting the splits within the Monetary Policy Committee on the direction of rates. At the last meeting, one member voted to cut rates, while two others voted to raise interest rates further. Swati Dhingra, who was the voter for a rate cut warned that the bank may be “underplaying the downside risks” for the UK economy and called for immediate rate cuts because of weak consumer spending and declining inflation. Speaking to the Financial Times, she said she did not see much danger of resurgent price growth given the “feeble” state of household demand. “I’m not fully convinced there’s some kind of really sharp excess demand in the economy coming from the consumption side,” she said. “I’m more concerned that we might be underplaying the downside risks.”
BoE Governor Andrew Bailey was more upbeat on the economy, saying he sees signs of “somewhat stronger” UK growth but warns that trends in productivity and investment meant that there was still a “very constrained” supply side of the economy. Speaking before the GDP data confirmed a UK recession, he noted that the downturn was “very shallow… what I would put more weight on actually is the indicators we have seen since that have shown some signs of upturn”. Bank of England Chief Economist Huw Pill said that borrowing costs are on track to fall so long as inflation declines as expected and CPI does not need to drop all the way to 2% for rate cuts to begin. He said that “monetary policy is now on a different path than we were over the course of last year”.
The direction of travel for interest rates is clearly lower, but market expectations for when the first cuts will come, and how many we will see this year, continue to be pared back. The data we have seen from the US this week on inflation highlighted the difficulties with the “last mile” of getting inflation back to target, an issue noted by Bank of England Governor Andrew Bailey and others. US CPI for January was 3.1% year on year, down from 3.4% in December but higher than the 2.9% level expected. The decline in the path of inflation remains intact but there were signs of stickiness in the shelter component and wider services. Inflation is still on a lower trajectory, but the data, combined with persistently strong labour market data indicates that the Federal Reserve can be patient in building confidence that inflation is on a sustainable path lower and that they can take their time in reducing interest rates, given the continued strength of the labour market. The latest US employment report reaffirmed the resilience of the labour market, with payrolls increasing by 335,000 in January, well ahead of the 180,000 expected. The unemployment rate remained unchanged at 3.7%.
Against a backdrop of a strong labour market and inflation potentially easing on a shallower trajectory, it is no surprise to see rate cut expectations shifting towards “higher for a bit longer” in the US. A rate cut in March, seen as a near certainty at the start of the year, now has a probability of just 11% per futures markets, while the first interest rate cut is now expected to be in June. Markets are now pricing just 87 basis points of rate cuts this year, down from 168 basis points just over a month ago. Markets are now more closely aligned with the expectations of the Federal Reserve, who see 75 basis points of rate cuts by the end of the year.
Before the inflation data was published, Fed Chair Jay Powell had continued the recent narrative from Fed members, highlighting that “the danger of moving too soon is that the job’s not quite done”. Powell noted that it is “historically unusual” that rate hikes have not triggered a sharper slowdown in the economy or the labour market. “The broader situation is that the economy is strong, the labour market is strong, and inflation is coming down,” Powell said; “My colleagues and I are trying to pick the right point at which to begin to dial back our restrictive policy stance. That time is coming.” Powell’s colleagues echoed his recent comments, with Neel Kashkari saying he expects 2-3 cuts this year with the Fed “not looking for better inflation data, we’re just looking for additional inflation data that is also at around this 2% level”. If they “see a few more months of that data, I think that will give us a lot of confidence.”
The Fed has a “window” in terms of being able to cut rates without policy moves becoming political as the US election draws closer. Rate cuts close to the November polls will be jumped on by Republicans as supportive of President Biden, whose approval ratings on the economy remain very poor despite low unemployment and solid growth. At a campaign rally, Donald Trump said he wants to replace Powell as Fed Chair accusing him of being “political” and predicting he would cut rates to “help the Democrats” this year. Trump told US media “it looks to me like he’s trying to lower interest rates for the sake of maybe getting people elected”. Trump said “I wouldn’t do that” when asked if he would offer a new four-year term to Powell in 2026. Trump will likely have much more to say on rates, and plenty of other subjects, in the coming months…
Have a good weekend,
Regards,
Anthony.
