Remember that thing called inflation?

All eyes on inflation again

Financial stability concerns that arose after March’s market turmoil have now mostly subsided. This can clearly be observed in the credit default swaps market (effectively a market that insures against default) for major banks, which has calmed significantly over the past couple of weeks. So, the focus now is very much back on the fight against inflation, and the week commencing 17 April produced a series of data releases that significantly changed the outlook. Employment and earnings data on Tuesday showed some tentative signs of labour market loosening, but nominal wages registered at much higher levels than expected with average pay including bonuses coming in at 5.9% for December 2022 to February 2023 versus consensus of just 5.1%. On the following day, the y-o-y CPI inflation figure for March was released which, while down from the previous month, came in higher than expectations at 10.1%. This of course followed February’s inflation print significantly overshooting expectations, too. In summary, inflation is running hotter than previously anticipated. 

April’s y-o-y CPI figure will see a notable drop compared to March, potentially by nearly two percentage points, but note that this will mostly be due to base effects playing out with the gas and electricity component of inflation. While energy prices faced by households will be the same in March and April, the nature of Ofgem’s price cap means they will be compared to different data points for the purposes of calculating CPI inflation and this alone will lead to a significant drop in April’s y-o-y CPI. Other base effects throughout the year and factors pushing down on inflation in absolute terms, such as collapsing shipping costs, should mean that y-o-y CPI inflation falls to around 4% by year end. However, CPI inflation from this point onwards is likely to be driven by services inflation that could be more sticky given the influence that wage costs play in setting prices within that sector.

Markets are now fully pricing in a 25bp increase in interest rates at the Monetary Policy Committee’s May meeting, and we share this view in light of the most recent labour market and inflation prints. This would take rates up to 4.5%. The pace of interest rate increases has been very rapid so it is important to emphasise that the full effects of monetary policy typically take around six quarters to be fully transmitted into the wider economy. As a result, we believe that MPC members will take the view that an increase in May will be the last hike in this cycle. We do, however, expect rates to remain elevated at 4.5% from May until the end of this calendar year given the likely stickiness of services inflation.

Rates remaining stubborn

April was always going to be a quieter month than March, with none of the three major central banks meeting as concerns around the banking sector wane. Rates are still volatile compared to activity pre-March, but double digit basis point moves have not remained the norm – at least for now. Attention in April has turned back towards incoming data, which is now key in the quest to find out exactly when central banks will stop increasing rates. Signs of slowing growth and inflation decelerating should be enough to see the Federal Reserve pause in the summer, but the outcome is perhaps slightly less clear for the European Central Bank and the Bank of England.

US consumer price inflation slowed more than expected in March to an annual rate of 5%, coupled with falling produce price inflation (2.7% year-on-year in March) which is good news for the Fed, but the slight increase in annual core CPI to 5.6% is not welcome. Assuming we see no further flare up in the banking sector, this is probably enough to ensure the Fed increases rates by another 0.25% in May. Markets are not fully discounting this outcome yet, with the probability sitting at 70% currently, but it’s the most likely outcome.

The market is still closely watching US banks’ use of the Fed’s liquidity facilities, which is published weekly, for signs of stress, and usage of the Discount Window and Bank Term Funding Program has fallen throughout April (although now has stabilised as banks seem keen on holding onto cash). All a positive sign, but the lack of visible data on deposit outflows has kept analysts cautious. Inflows into money market funds are one telling sign of deposit outflows from banks, depositors are attracted to higher returns offered from money market funds, and this has been exacerbated in recent weeks by the banking turmoil. What is not too clear is how much funds are flowing from smaller regional banks to the larger US banks, labelled systemically important. 

Across the Atlantic, focus very much remains on fighting inflation, with contagion from the banking sector remaining minimal. Officials at the European Central Bank are sticking with a hawkish tone, and known hawks such as the Austrian and Latvian governors Robert Holzmann and Martin Kazaks are keeping the option of another 50bp hike on the table next month. Markets are positioning for that very possibility with 30bps priced in for the May 4 meeting, suggesting that we will at least see a 0.25% rise with a 20% probability of a 0.5% rise – taking the deposit rate to 3.25-3.50%. ECB President Christine Lagarde also reiterated that inflationary pressures remain strong when speaking in Washington, but gave very little else away, whilst Isabel Schnabel,  who sits on the ECB board and who is someone markets tend to listen to more than most, said the outcome is too hard to call. Annual core inflation in the Eurozone is still running hot at 5.7% which is likely to keep the ECB hiking into the summer, with the markets applying roughly a 50/50 chance of the peak reaching 3.75% by September.

New member of the MPC appointed

Chancellor Jeremy Hunt appointed Megan Greene as a new member to the Monetary Policy Committee in early April who will replace the outgoing dove Silvana Tenreyro from July onwards. Ms Greene is currently global chief economist of consultancy firm Kroll, based in the US. Judging by previous work and comments, early signs suggest she will join the majority of the centrists in the MPC. Greene has recently supported the view that the Fed should continue raising rates despite the recent turmoil and stated that rates will not be cut in 2023. However digging further back, there is apparent pessimism surrounding UK growth prospects. It is too early to tell what this means for actual voting outcomes, but it is clear that one of (if not) the most dovish members of the MPC is not being replaced like for like. Another vacancy will be available later this year as Jon Cuniliffe retires.

As for the upcoming May meeting, markets are fully pricing in another 25bp rise taking bank rate to 4.5% following the sticky March wage and inflation data. Markets now also see another 0.25% rise in June and have even put 5% back on the radar as the peak for later in 2023. Recent comments from Chief Economist Huw Pill, prior to the labour market and inflation releases, also suggests further increases may be on the horizon (without any explicit forward guidance) after he stated in a video conference that the UK may be experiencing “a positive demand shock”. With unemployment forecasts slightly merrier than before, Mr Pill said that this is “supportive of consumption” whilst he is also concerned that the recent moderation in wage momentum has become stuck. However Mr Pill did caveat that there is a risk of doing too much as well as too little.

Long-term swap rates are not much different to where they were at the beginning of March. 5 and 10-year rates still at a discount to bank rate, but way off the lows seen around 24 March. The fall in the back end of the US curve in recent weeks has not filtered through to the UK, despite anaemic growth expected in the coming years. We can see this in the government bond yields too where UK gilts trade at a premium in the 10-year sector. Clearer vision regarding the inflation path and subsequently when the Bank of England will start cutting rates is likely needed before we see a significant move lower in swap rates. Whilst we cannot say the US influence has completely diminished, the recent banking woes which have remained localised in the States has created some divergence, meaning rate paths may be tied closer to domestic stories – I emphasis the word “may” however…

Cameron Willard, Capital Markets

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