30 March 2023: Rate increases to end in May

The popular view in the markets currently is that the Bank of England will call a halt to its long-running programme of rate hikes in May after raising short term rates once more.

There is a degree of optimism about the economy which is leading commentators to believe that the bank won’t need to cut interest rates to stimulate the economy unless there is any further fallout from the recent collapse of two U.S. banks which has precipitated a liquidity crisis.

The Central Bank is trying to encourage companies to invest in their businesses. The level of purchases of new machinery and plant by businesses of all sizes has not really recovered from the near collapse that was seen during the Pandemic.

No matter how much confidence grows that the Government is now on the right track, with inflation falling which will lead to an increase in real wages, there is still the political uncertainty generated by opinion polls which still put the Labour Party well ahead and therefore barring some unforeseen disaster likely to be elected to power after thirteen years in opposition early 2025.

Following the somewhat bizarre events of last summer that followed the election of Liz Truss to succeed Boris Johnson as Conservative Party leader and Prime Minister, the country is gradually returning to its more traditional beliefs. The first is that under a Labour Government, public sector borrowing rises considerably as investment increases in services and social care.

It is believed that the NHS is in safe hands under a Labour Government, although there are similarities now between the two parties as they have realized that they both need to fight for the middle ground.

While Labour has cast aside its left wing ideologies when its leadership moved from Jeremy Corbin to Sir Keir Starmer, the more radical right within the Conservative Party which was represented to a certain extent by Liz Truss has been muzzled as is shown by the Windsor Framework agreed by new Prime Minister Rishi Sunak in defiance of hard core Brexiteers.

As the economy recovers somewhat from the shocks of Brexit and the Pandemic, there are some issues that are being baked in. For example there are shortages that are likely to remain for some time in finding both skilled and unskilled workers. That is leading to higher wages being demanded. This feeds directly into inflation.

Andrew Bailey believes that the number of skilled workers who have taken early retirement following coronavirus is to blame, the Government faces calls to incentivize people to remain in work until they reach the traditional retirement age of 65.

With Growth expected to be flat overall this year, there is a growing belief the right conditions will be in place for the GDP to grow at close to 3% in 2025. This is unlikely to sway voters who have reached a point where they believe that a change of Government is due.

The financial markets are in something of a state of flux at the moment, wanting to believe that the liquidity crisis won’t get any worse, but still concerned that there may be issues lurking just below the surface ready to come to the surface and bring further volatility.

The pound ran into some selling pressure as it tried to extend its recent gains above the 1.2350 level against the dollar. It fell back to a low of 1.2302, closing at 1.2312.

Existing home sales rose unexpectedly last month as long-term interest rates began. The public wants to believe that Janet Yellen and Jerome Powell have the situation that has led to a liquidity crisis being suffered by, mostly, regional banks under control. As in the UK, investors are still concerned that the situation hasn’t completely gone away and there are still some stresses remaining.

It is notable that at the first sign of stress, banks tend to withdraw lines of credit to each other rather than trying to shore up confidence.

A mixed report on the level of stockpiles of oil led its price to fall yesterday. A view that the Chinese economy is returning to strength has been balanced by the continuing feeling that there may still be a recession in the U.S.

Although there is a continuing belief that the Federal Reserve will halt its programme of rate hikes in May, Jerome Powell is unlikely to want to confirm that until he has in his hands solid proof that inflation is under control.

He clearly has had a difficult time at the past two FOMC meetings, most likely being outvoted when calling for rates to rise by fifty basis points.

In January, the meeting was held before the December employment report was published. It showed an incredibly high number of new jobs had been created, which given the data reliance of the bank would have likely led to a fifty point hike, while in February, the liquidity crisis was just beginning and FOMC members would have wanted to err on the side of caution.

Next week’s March employment report together with inflation data may go some way to convincing Powell that the time is right to call a halt to rate hikes.

It is clearly easy to say you are data driven when the data backs your view, but less so when the time comes to pivot. It is a judgement call to expect subsequent months to follow a pattern that is driven more by hope than expectation.

Risk appetite has grown this week as the market treats the lack of any fresh crisis with suspicion. The dollar index has retreated somewhat and now seems to be struggling to make progress, while the Fed is seemingly undecided about ending rate hikes.

Yesterday, the index rose a little as it bounced off support at around 102.40. It climbed to a high of 102.78, closing at 102.65.

There is no clear trend currently, with several contrasting drivers remaining. In particular, the expectation that Central Bank influence will slowly recede in the coming months. stabilize, allowing buyers to have confidence in taking on greater household commitment.

It is difficult to see the ECB being able to continue to hike rates beyond the end of the second quarter, since beyond that time they will have, almost certainly, have reached a level at which they are restricting demand and therefore economic activity.

Within the borders of the frugal five, the public believe that they are being protected from inflation by rising interest rates, which also see them get a return on their savings which they believe is right and proper since they believe that they have spent an excessive amount of time subsidizing the rest of the region.

Within the more indebted nations, there is something close to indifference, since they have a history of high inflation and often interest rates that reflect price increases in their economies.

The European Commission can point to Greece as a success story, pointing out what can be achieved with fiscal discipline and a considered approach to public spending. Italy, Portugal, Cyprus and to a slightly lesser extent Spain, remain unconvinced about applying the same methods to their own economies, fearing the probable electoral backlash of austerity.

Italy is a case in point. It recently elected its most right wing Government in decades only to find that the Prime Minister Giorgia Meloni is prepared to work with Brussels as long as it makes certain concessions.

Italy suffered not only the first infections, but also the highest number on the mainland from Coronavirus, but the leniency it was shown as the growth and stability was suspended meant that it was able to defer the pressure to reform its welfare programmes which are considered over generous.

There will be a day of reckoning for Italy. So far it is in the shape of higher interest rates, but as long as the ECB continues to implicitly guarantee Italian Government Bonds, Italy will continue to flout the rules.

The second half of 2023 will most likely see inflation begin to fall, although there is some reliance on the war in Ukraine staying within the territory it currently occupies.

There is a significant disagreement brewing with Romania and Bulgaria over the level of support Brussels is prepared to offer over the shortages of grain that these two countries in particular are suffering while Ukrainian exports remain at historical low levels.

The single currency remains in a relatively narrow, although higher, range. It is hemmed in by sellers around the 1.0920 level, while it is attracting buyers around 1.0780. Yesterday, it was unchanged on the day, opening and closing at 1.0844.

Have a great day!