Ear to the Ground

May 26 2023

The good, the bad, but hopefully not the ugly.  The UK had news this week which quite nicely fits into all three categories.  Starting with the good, we saw the International Monetary Fund (IMF) upgrade their economic forecast for the UK this week.  In their latest report they no longer expect the economy to suffer a recession this year.  They now believe that it will grow by 0.4%, which is a marked improvement from their previous expectation of a 0.7% contraction.  This, along with the near zero growth rate expectation for Germany means that we are no longer expected to be the weakest economy in the G7. 

Despite the positivity, the IMF did predict that there is yet more cost of living pain to come.  They expect that the interest rate hikes which we have seen will not make their peak impact on demand and inflation until the second half of 2023.  The report suggests that UK inflation will not return to the 2% target now until mid-2025.  They also predict that interest rates will have to rise from the current 4.5% level.

It was almost as if they had received insight into the inflation print which we saw later in the week.  Whilst the headline consumer price index (CPI) fell from its previous reading of 10.1% to 8.7%, the latter was still much higher than the consensus forecast of 8.2%. 

What perhaps will be of great concern to the Bank of England rate setting committee was the continued rise in core CPI.  This came in at 6.8%, which was way above the March reading of 6.2% and the consensus forecast of 6.2%.  This provides further evidence that inflation could perhaps prove stickier than first envisaged and that attaining the 2% target for headline CPI is going to take yet more work.

Following the higher than expected inflation print, the forecast for UK interest rates hikes took a jump.  Markets, as indicated by overnight index swap rates, now forecast that interest rates will now reach at least 5%, from the current 4.5% level, and could even reach as high as 5.5%.  This latter figure could yet prove an overreaction, but one to watch, nonetheless.

If these forecasts were to prove the case, it is more than likely that this would have negative connotations for economic growth.  By the end of this year, according to figures from JP Morgan, almost 40% of fixed rate mortgages will have come to an end and the consumer will be looking to refinance at a likely much higher rate than the one they are moving from.  By the end of 2024, 60% will have been renewed.  This surely has to have a negative impact on the consumers spending power via a lower disposable income.

Finally, if the UK base rate is to rise to the expected levels, this has to give rise to an upward shift in bond yields.  At 4.56% we are now at a rate above the peak seen in October following the mini budget.  This causes a great deal of stress for the pension industry, in particular Liability Driven Investing (LDI).  Let us hope that pension schemes are better prepared this time around, or that cracks don’t appear anywhere else.

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