Higher for Longer

Global equities last week reversed part of their decline earlier in August, rising 1.5-2% but remaining a similar amount down on their end-July high. Just as the earlier retreat was caused by a rise in bond yields to new highs, the better tone of late was accompanied by yields falling back somewhat. 10-year government bond yields have retreated in the US to 4.1% from their recent high of 4.3% and in the UK to 4.4% from 4.7%.

The latest US economic data have boosted hopes that the Fed might actually succeed in pulling off a soft-landing. Growth is off to a firm start in the third quarter yet crucially the previously red-hot labour market continues to cool. Employment growth has slowed, the unemployment rate has edged higher, job vacancies are back down to more normal levels, and wage gains have moderated.

Underlying inflation pressures have eased significantly and core inflation on the Fed’s favoured measure is currently running at 4.2%. Although US rates have probably now peaked, Fed Chair Powell has continued to emphasise that inflation remains too high and the battle is still not won.

In the UK and Europe, recent numbers have been weaker than expected. Business confidence fell into recessionary territory in August, stirring up worries that these economies could see a mild downturn later this year or early next. This is certainly possible but it is worth noting that companies were equally pessimistic late last year, sparking similar such fears which turned out to be misplaced.

The performance of the UK since the pandemic remains a hotly debated topic and the latest GDP revisions have not for the first time up ended the prevailing narrative. The statisticians now believe the economy is almost 2% larger than previously thought, reversing previous downward revisions. Rather than remaining 1.2% below pre-pandemic levels by end-2021, it now believes the economy was 0.6% larger, bringing the UK into line with other countries.

These revisions will no doubt reignite the debate on how much damage Brexit has done to the economy but should have little impact on monetary policy. The hot topic here remains how much further rates have yet to rise and how long then before they are cut. The BOE’s chief economist weighed in on this debate last week, arguing the merits of rates remaining higher for longer rather than spiking higher for a shorter period of time.

The Fed and ECB have also recently been warning that rates will have to remain higher for longer. Indeed, with their credibility damaged badly by their gross misreading of inflation on the way up, central bankers everywhere will be wary of cutting rates too early for fear of having then to reverse course, which would be embarrassing to say the least.

Interest rates in the West look unlikely to start being cut before next summer. And in the UK, the case for no early reduction is all the greater given inflation pressures appear more entrenched than elsewhere. With no easing yet in underlying inflation unlike in the US, a further 0.25% rise in rates to 5.5% still looks on the cards later this month. The ECB could also well raise rates again as core inflation of 5.3% remains way too high for its liking, even if it is considerably below the 6.9% level of the UK.

In China, it remains a very different story. Policy remains wholly focused on boosting growth and limiting the damage from the downturn in the property sector and new support measures have been announced in the last couple of weeks. Interest rates are being reduced further, stamp duty on stock trading has been cut and restrictions on home purchases relaxed. These measures will not transform the economic picture overnight but do suggest the current intense gloom about China is overdone.

Rupert Thompson – Chief Economist