Posted 9 May 2023
Overview: rate sensitivity and banking failures set the tone
With the coronation bank holiday behind us, the UK’s attention turns this week to the Bank of England (BoE), with its Monetary Policy Committee (MPC) expected to raise rates by 0.25% to bring the UK’s base rate to 4.5%. Last week, both Jerome Powell at the US Federal Reserve (Fed) and Christine Lagarde at the European Central Bank (ECB) managed the neat trick of sounding hawkishly dovish, while both raised rates by 0.25% to 5.25% and 3.25% respectively, in line with expectations.
US jobs data keeps sending positive signals, with the latest non-farm payroll data refusing to show weakness. Revisions for previous months were negative but not massively so. Cyclical sectors did show some job losses, but these were made up for by gains in sectors that have had difficulties in recruiting in past years – health and education particularly. That means the resilience is there, and gaps opening on the cyclical side are being filled by other sectors and those hiring sectors are not especially rate-sensitive.
For us, rate sensitivity is what it’s all about. Households are currently not sensitive to short-term rates, given the pandemic payments meant short-term borrowing got paid down, while long-term mortgages were refinanced at very low rates (more so in the US than elsewhere). Jobs being still plentiful, consumption remains at healthy levels although no longer buoyed by the ‘excess’ savings from the pandemic payments. But rate sensitivity is much more apparent in the world of small businesses, in real estate, and among private equity – all areas that matter greatly in the overall economy.
Risk assets have done reasonably well in recent weeks, as global growth indicators improved through the first quarter. Recently these growth indicators have become more mixed again but, in the most important area of jobs, they remain buoyant. That means central banks will be reluctant to ease off and supply the rate cuts which are already discounted in the bond markets. Small and mid-sized firms may be able to catch occasional small breaths but have been squeezed for a long period now and are running out of oxygen. The most timely signal to cut rates comes when, for those firms, it’s already too late – default and bankruptcy indicators lag until the moment they pick up but then they come in a rush. Time is getting shorter. If central banks wait for a clear decline in inflation, it will probably be too late for quite a lot of smaller firms.
Central bank watch: slowing but not yet pivoting
The Fed was widely expected to delivery another 0.25% rate hike in its May meeting, and it did not disappoint. US benchmark interest rates are now in the 5-5.25% range, breaking the 5% level for the first time since before the 2008 Global Financial Crisis. Expectations are that the Federal Open Markets Committee (FOMC) will take a break at its next meeting, with the implied market outlook implying no more rate rises for the rest of 2023. This is backed up by work from the Fed’s own researchers suggesting US growth will turn negative this year. Fed Chair Jay Powell does not believe the inflation fight is already won. But the particular stress on small and medium-sized businesses – originating from the banking crisis – certainly affords the FOMC some extra leeway. It could well be that economic tightening – which historically has always lagged rate rises by some 6-12 months, is already locked in, in which case the Fed would have little need to raise rates further. Should that happen, the market assumption will be that the Fed should start gently easing, perhaps as soon as later this year. We would caution against getting too excited about this idea; it will likely only happen if the economy materially worsens.
The BoE is in a very similar situation to the Fed. Inflation has proven stubbornly high and policymakers are deeply concerned about tightness in the labour market. Governor Andrew Bailey is fully expected to deliver another 0.25% rate rise next week, but economists predict this will be the last hike of the current cycle. UK inflation should continue to come down from here, as the UK economy is simply too weak to sustain such high levels. This is despite a recent halting of the fall in house prices, as well as the highest consumer confidence figures in more than a year. Even with this positivity, there is little steam to push UK prices higher in the months ahead. Indeed, while economist forecasts for 2023’s year-on-year consumer price index (CPI) inflation rate to be above 6%, the inflation swap market (used by pension funds) now sees CPI inflation at only 2.3% by the end of April 2024. Economists are probably overly pessimistic.
Meanwhile, the ECB has been slower than its British and American counterparts in the fight against inflation. The decision to raise its three key interest rates by 0.25% to 3.75%, 4.00% and 3.25%, respectively was a mildly dovish outcome. Unlike the US, labour market tightness has not been as pronounced at the aggregate level. Instead, historic inflation has all been about the war, the withdrawal of Russian gas supplies and an energy crisis. Given these fears have eased after a warmer-than-expected winter and improvements in gas storage, one might think Europe’s inflation problem has blown itself out. But just as the internal slowdown is now feeding through in the US, we expect the European economy to weaken into the second half of this year, although sometime after the US.
Ultimately, inflation is unlikely to fall unless growth weakens too. The fragmented nature of the European Union, with vastly different political imperatives, makes ECB President Christine Lagarde’s job of finding the right balance extremely difficult. The ECB has been good at liquidity management for many years, but navigating competing economic needs to find the right rate policy mix is a much more difficult task. It will likely be the defining struggle of her tenure at the ECB.