Are we near the end?

February 2023

The economist's corner

It seems rare these days to read any good economic news, so let us start with some positive developments since the last Handelsbanken Rate Wrap. The Bank of England (BoE) published its latest inflation report earlier in February and the outlook for the UK economy has seen a notable improvement, in large part owing to spot and future energy prices moderating (See Figure 1). Inflation projections are looking far more sanguine with the BoE’s Monetary Policy Committee (MPC) now predicting CPI inflation will be down to just 4% by year end. While a recession remains the base case scenario in 2023, it is expected to be shorter and shallower than previously expected. There was also an unexpected bright spot towards the end of 2022 with business investment seeing strong growth of 4.8% in Q4 (see Figure 2), which helped the UK to avoid a technical recession last year. And the composite PMI index (which measures purchasing managers’ views of business conditions) for February dramatically exceeded expectations by registering well above 50. This indicates economic expansion and could suggest that forecasters are being too downbeat on short-term growth prospects for the UK economy.


Despite some reasons for cautious optimism, the UK economy remains the only G7 nation not to return to its pre-pandemic GDP level and its prospects for 2023 continue to be held back by specific factors, including impacts on trade arising from Brexit, tight fiscal and monetary policy as well as a growth in inactivity levels following covid. Furthermore, it is notable that the strong PMI figures do not account for the retail and construction sectors – which are likely to face strong headwinds – and questions also remain about how sustainable the recent boost to business investment will be. The super-deduction, allowing businesses to cut their tax bill when investing in qualifying new plant and machinery, is due to come to an end in March, while around four fifths of business loans are on floating rate, meaning monetary policy tightening is passing through to companies especially quickly and hitting profitability. Chancellor Jeremy Hunt will have an opportunity to incentivise momentum in business investment at the Budget on 15 March – and he has, indeed, indicated that he will prioritise alleviating tax burdens on businesses – but we have to be mindful that any changes announced are likely to be small in fiscal terms.

After the Budget, attention will naturally turn to the March MPC meeting the following week. We are clearly coming to the end of the BoE’s interest rate hiking cycle but there remains some uncertainty about where rates will peak. UK inflation is finally firmly on a downward trajectory with CPI falling to 10.1% y-o-y in January, below consensus and down from the previous month’s reading of 10.5%. The BoE will especially welcome this drop in headline rate given it was driven by a 0.5pp fall in the core rate of inflation. Yet at the same time, many MPC members will remain worried about the inflationary impact of nominal wage growth that remains very high in historic terms with, for example, regular pay climbing since early 2022 up to 6.7% y-o-y in the period October to December 2022. The latest unexpectedly robust PMI figures could also push MPC members in a more hawkish direction. The likelihood of rates being increased by 25bp at the March meeting, rather than being held at 4%, has certainly increased, but further data releases in the coming weeks will provide more certainty about whether we are already at peak rates.

Daniel Mahoney, UK Economist

A view from the dealing desk

Is the end in sight?

February’s central bank decisions came in line as expected, but the supporting forecasts and resulting press conferences provided a dovish tilt for the markets to digest – whether intentional or not. First was the Federal Reserve which raised rates by 0.25% as expected, taking the upper band of the Fed Funds rate to 4.75%. The slowdown in the pace of increases came as no surprise following a slew of data pointing to stagnant growth and slowing inflation, however the main talking point was whether chairman Jay Powell would push back against market expectations of rate cuts later this year or next.

Whilst the statement still inferred that the Fed sees more increases to come, reiterating that further evidence is needed to show inflation normalising before it can consider its job done, there was no clear and obvious pushback from Mr Powell on current financial conditions and market pricing. This suggests that the Fed is getting closer to the view that its hiking cycle is near an end and that focus can then turn to the growth outlook, with confidence that inflation will move back towards the 2% target. Note that Mr Powell and co were never going to clearly endorse this view, it’s a central banking no-no to support the discounting of rate cuts at a time when it’s still raising rates (it muddies the waters and makes any further effort to tighten policy ineffective), but no signs of agitation did suggest the Fed is quietly comfortable, and talk of “disinflation” certainly caught the eye. This got the market rather excited, perhaps overexcited, with Treasury yields falling post-decision, and the markets firming up their view that the Fed Funds rate will not exceed 5%. 

The domination of the doves continued the following day with the European Central Bank and the Bank of England. Starting with the former, the decision and accompanying statement was in line with the hawkish message everyone was expecting. Benchmark rates were increased by 50bps, taking the deposit facility rate to 2.5%, and the supporting comments confirmed that another 0.5% increase was expected in March – so far so good.

But the ECB’s, and in particular Christine Lagarde’s, achilles heel again surfaced – communication. By the end of the press conference the markets seemed more confused than anything, rather than reiterating the hawkish message it seemingly intended to, a few dovish snippets caught the markets’ eye. The first point was the reiteration of being data dependant. Whilst not being intrinsically controversial, the market interpreted this as a sign the central bank is aware of the slowing inflation in the Eurozone, and is not confident in its current forecasts (which was the case when inflation was on the way up). This was backed up by another comment that the inflation outlook is now “more balanced”, rather than highlighting upside risk. Again, bond yields tumbled in the afternoon following the press conference, with the 10-year Bund and Italian BTP equivalent dropping 20bp to 40bp respectively.

Lastly, onto the Bank of England. This probably caused the least amount of surprise out of the big three. The MPC voted in a 7-2 split to increase bank rate by 0.5% to 4.00%. This was in line with most analysts’ expectations, as well as the market’s. The two dissenters, Silvana Tenreyro and Swati Dhingra, voted again for no change – also unsurprising. If anything, the updated Monetary Policy Report was even more clear that market pricing is wrong. Firstly, inflation in 2 years’ time based on bank rate at 4% is just 0.95%, and even lower at 0.83% based on the market curve. If that was not enough, then a tweak in the statement also suggests an end is near. The statement did not refer to the need for “ongoing tightening”, only suggesting further tightening would be required if there is evidence of “persistent” inflationary pressures.

With the increase in bank rate to 4%, we are now in a situation where forward looking swap rates sit lower than bank rate itself. Put simply, and referring to market levels only and not including costs, it is now cheaper to fix for 5 or 10 years than to borrow against bank rate. Swap rates do include forward market expectations, so they do assume rate cuts down the line, but hedging may now be looking more attractive than it did when there was a 2%+ differential between bank rate and swap rates in the summer of last year.


What a difference, a day makes…

Fast forward a day on from the central bank meetings and you have a whole new picture to digest, and the blame is aimed at the outrageously strong US payroll data. The consensus was looking for an increase in payrolls of 190,000, after an increase of 260,000 in the previous month. Hints from other surveys and sample data suggested that the labour market is taking a turn, with layoffs increasing, hiring intentions falling along with the quit rate. The private payroll report released by ADP a couple of days prior printed a 106,000 increase, so even 190k looked optimistic.

So what was the actual number? 517,000. This blew every expectation out of the water, with the most bullish forecast at around 320k. Not only this, but the unemployment rate fell to 3.4%, below estimates too. This caused some mini market mayhem. Yields spiked higher, equities fell and the dollar rose. The 10-year Treasury yield jumped 30bp off its lows after the central bank decisions, whilst the 10-year Bund jumped 25bp off its trough. 

It remains to be seen whether this was just an anomaly, and it does look likely. Firstly there was a big increase in government payrolls, but the majority can be labelled as re-hiring of education workers who were on strike in November and December, so not a true increase. Whilst the increase in private payrolls was broad-based, it was boosted by favourable seasonal adjustments. January 2023 saw a significant drop in the number of job losses compared to previous years, due to warmer weather and less snow. Therefore actual hiring may not be that strong. However the more important point is that wage growth is still stagnating, with annual average hourly earnings dropping from 4.8% to 4.4%. 

All in all some suggest we may be looking at a “goldilocks” scenario with normalising inflation (which slowed again in January) and a tight labour market, which would suggest only a shallow recession at most. Further releases of January data, including strong retail sales (3% month-on-month in January), support this too, underpinning overall market optimism. 

But on the flip side this also supports the Fed’s reiteration of inflationary concerns and belief that it will take longer to tame, bolstering the argument of a well-known phrase that you “should not fight the Fed”. The data releases have now taken market expectations for the Fed Funds peak above 5%, potentially to 5.25% or higher, whilst also pricing out rate cuts this year (the market sees a strong chance of one 25bp cut, but it’s not fully priced in). 

The subsequent data has led to some further hawkish remarks from Fed members, albeit not from Jay Powell when he spoke at the Economic Club of Washington DC, providing the market with some relief.  ECB members seem to have successfully completed their firefighting mission to undo the communications confusion too, with markets’ rate expectations moving higher.


Chinese caution, jury’s out on Japan

Finishing on some topics mentioned in last month’s Rate Wrap, namely China’s re-opening and Japanese monetary policy. On the former, the optimism surrounding China remains just about intact for now, but momentum is fading and cracks are starting to appear. On the one side, domestic-driven growth looks a real positive, but growth via exports may struggle for two reasons: 1. A slowdown in western economies will naturally reduce demand for imports, and 2. Strains in the US-China relationship have intensified. The latter matters for various reasons, but none more so than the sharing of technology which has significant multiplier effects on supply chains and long term growth. The US has pressured the likes of Japan and Korea to stop exporting certain technology, such as semiconductors to China, and this pressure will only intensify following the spy balloon incident this month. China is likely to retaliate by also banning technology exports, including the likes of solar panel technology. This is not a good sign for the short or long term, and will have growth and inflationary impacts. We will watch this closely, and see if further talks will be scheduled between Secretary of State Antony Blinken and China’s political hierarchy.

On Japan, we now know who will replace Governor Kuroda in April. There has been much speculation about his replacement, and whether it will be a continuation of the dovish stance, or a hawkish candidate that rips up the script. It became clear that the government’s preferred candidate was Masayoshi Amamiya, the current Deputy Governor, which would have been viewed as continuation of the norm given he is seen as a dove, like Mr Kuroda. However Nikkei reported that Mr Amamiya turned down the opportunity, sparking a market reaction with the yen rising.

Prime Minister Kishida has now nominated former BoJ board member Kazuo Ueda to take the helm. It is unknown what exact stance he will take yet, but in the past he has expressed his caution for raising rates prematurely, and his hearing remarks were of a similar tone. This whole process has suggested that Japan has wanted some form of consistency within the committee, rather than shaking things up which it could have done by nominating names such as Hirohide Yagamuchi (head of the government pension fund), or Hiroshi Nakaso. Both, who are former deputy governors, are seen as more straightforward hawkish candidates.

Regardless of the outcome, the Bank of Japan will still likely budge from its uber-dovish stance, even if the committee believes that inflation is mainly supply driven and will reverse. Annual nominal wage growth in December came in at 4.8%, the highest since the early 90s, while headline inflation is running at 4+%, it is not something that can be ignored. Although not a base case, the implications of more attractive yields in Japanese assets may have a significant impact on western market rates – particularly the US. This “repatriation” trade would require Japanese investors who own roughly $1.08trn (as of Nov 22) worth of Treasuries, to sell US bonds, reducing the value and lifting interest rates – this is happening gradually already, but any sudden shift will conflict with the current market setting of a deeply inverted interest rate curve. This topic is surely be one we will circle back to in the future.

Cameron Willard, Capital Markets

All data in this article, unless otherwise stated, is sourced from Bloomberg

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