November 4 2022
This week has again been dominated by central bank actions. Here in the UK, we had the Bank of England working busily. Firstly they auctioned their first tranche of government bonds as they looked to reduce their balance sheet holding of £838bn. They sold £750m of gilts which had a remaining maturity of between three and seven years. The auction had very little impact on gilt yields, and in a sign that demand is high for higher yielding fixed interest, investors bid for 3.26 times the amount which was up for grabs. This was the first auction of many, with the Bank looking to sell £6bn of gilts across eight auctions during November and December.
On Thursday we then had the MPC announce their interest rate decision where, as expected, the base rate rose by 0.75% to 3%. This is the highest level which we have seen in 14 years and signals the Banks intent to tackle inflation. Despite the move of this magnitude, they were however quick to point out that they believe the terminal rate currently being priced into markets was too high. Ahead of the meeting the market had been pricing in a peak of around 5.25%. The peak is now forecast to be somewhere between 4.25% and 4.5%, although as we have seen, this is subject to change, a change which can be material.
The Bank now forecast inflation to peak at 10.9% before falling back to target over a three year window. The length of the window suggests that inflation in some parts of the economy may prove a little stickier than others.
Perhaps the starkest warnings however came regarding the economy. They forecast the outlook to be very challenging. Some forecasts suggest that the UK is already in recession and the GDP could decline for eight consecutive quarters, taking us to the middle of 2024. They also forecast that unemployment will rise from 3.5% to 6.4%, something that will help them bring inflation under control.
Higher interest rates could also potentially take their toll on the UK housing market. Lloyds Bank forecast that house prices will fall by 7.9% in 2023 and 0.5% in 2024, before picking up again in 2025. In a severe economic slump they forecast a fall of 17.9% in 2023 and could continue falling until 2026. The worst case scenario from the Nationwide meanwhile has house prices falling by up to 30%.
In the US the Federal Reserve also met to set interest rate policy. They also moved in line with expectations, with a base rate hike of 0.75% to a new range of 3.75% to 4%. Initially the market reacted positively to the statement released, interpreting it to be a little more dovish than anticipated. Chair Powell however was a lot more hawkish than anticipated and the equity market reacted rather negatively to what he had to say. To use a football analogy, it was a game of two halves.
He made it clear, in no uncertain terms, that further rate hikes were to come. Although there was perhaps some leeway in terms of the size of future rate hikes it was made clear that they remain committed to going further. He also set clear that it was the ending peak rate that was more important than the number and size of future moves to get there. Statements including that it is “very premature to think or talk about pausing our rate hikes”, “we still have some ways to go and incoming data since our last meeting suggests that the ultimate level of interest rates will be higher than previously expected” coupled with “if we overtighten, we will be able to support economic activity with our tools” well and truly pushed back any expectation of a ‘Fed pivot’. The market is now pricing in a terminal rate of 5%, above the last dot plot median which indicated 4.5% to 4.75%.
The US Treasury 10 year-2 year yield curve is now at a level of inversion not seen since 1981. Whilst a yield curve inversion does not cause a recession it has been a very strong indicator that a one is on its way. It tends to be as the yield curve starts to steepen that we see the start of a recession officially recognised. Whilst a good indicator that one could be around the corner, it is a weak indicator as to when it will/could occur. Markets are likely to price in a recession well ahead of it being officially declared, however.
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