18 December 2024: The market suggests that UK borrowing could reach its highest point in over thirty years

The Bank of England’s decision on whether to cut rates at tomorrow’s meeting of the Monetary Policy Committee was made easier yesterday by the news that average earnings grew by 5.4% in November.

This was well above the market’s expectations and signals that inflation is not yet controlled. The increase was almost totally due to wage increases in the private sector. This matters for the Bank because private sector pay trends tend to be more reflective of the wider situation in the jobs market than in the public sector.

These numbers can be volatile, and it’s hard to pin an obvious reason on the latest surge. But it will heighten suspicion among BoE hawks that wage growth is not going to readily come back down to pre-Covid levels.

However, the job market is cooling overall. Although the unemployment rate was unchanged at 4.3%, as expected the vacancy rates are falling considerably.

Traders and investors are rightly suspicious of data published by the Office for National Statistics since its admission that the quality of their output relies on outdated models which were due to be replaced, but that now won’t happen until 2027.

Vacancy rates across the vast majority of sectors have fallen below pre-Covid levels in recent months. The supposedly more reliable payroll-based employee data shows that employment, outside government-heavy sectors, is down by almost 1% so far in 2024, having fallen further in November.

The Government would be grateful for a series of “wins” but the news that the Prime Minister has decided that female pensioners who were affected by the change in the retirement age will not be compensated will see his popularity fall even further.

As Sir Keir Starmer’s Cabinet has reached its 6-month milestone, which signals that 10% of this Parliament has passed already, it is hard to imagine a more rapid fall in any earlier Government’s popularity rating.

The public would have accepted that the Cabinet faced a tough situation, but accusations that it misled voters by saying that there would be no tax increases have seen public confidence plummet, while the treatment of farmers and pensioners has been unpopular, not to say scandalous.

While voters would, in normal circumstances, give a new Government the benefit of the doubt, almost every policy is now being questioned. For example, no one seriously believes that 1.5 million new homes will be built over the next five years.

Government borrowing costs are poised to reach a 34-year high compared to Germany, amid growing uncertainty about how quickly the Bank of England can lower interest rates.

The gap between UK and German 10-year bond yields, known as the credit spread, has expanded to as much as 228 basis points following data that revealed a significant rise in wage growth.

If this trend continues, it will represent the largest difference between British and German government borrowing costs since the early days of German reunification in 1990, surpassing the levels seen during the bond market crisis triggered by Liz Truss’s mini-Budget two years ago.

The pound was buoyed by the markets’ belief that the Bank of England will struggle to cut interest rates four times in 2025.

It climbed to a high of 1.2728 yesterday and closed at 1.2708.

For a considerable time between the last FOMC meeting and now, the market was settled in its view that interest rates would be left unchanged when the rate-setting committee announces its latest decision later today.

Many FOMC members spoke in the week leading up to the “news blackout” of their view that rates would continue to be lowered, but the cuts would be gradual, while Jerome Powell said that there was no pressure to cut rates given the robust nature of the economy.

However, that view has changed over the past week to ten days, even though it is hard to determine what caused the market to change its mind. The two main drivers of monetary policy, employment and inflation, have both been at levels that would normally indicate no change in interest rates.

The latest employment report showed that 227k new jobs were created in November, while the October report’s 36k new jobs created were easily explained by the storms that afflicted the country and strikes in the aerospace industry.

Consumer price inflation rose to 2.7% in the year to November, up from 2.6% in the year to October. Stripping out food and energy prices, so-called core CPI inflation stood at 3.3% for the fourth month running.

Markets greeted these numbers as largely in line with expectations and concluded there was no need to adjust their forecast. But that’s the wrong test. The question isn’t whether the latest numbers were a nasty surprise, but whether inflation is on track to return to its 2% target.

Right now, that isn’t so clear. Core inflation’s decline from its peak of nearly 7% in 2022 may have stalled, with prices still rising somewhat faster than the Fed’s target.

To be sure, there will be pressure pushing both ways over the coming months. Note as well that the Fed focuses mainly on the personal consumption expenditure measure of inflation, not CPI. PCE inflation is running closer to the 2% target because it gives less weight to the cost of shelter and rising rents have been a main factor in keeping CPI inflation up. Shelter costs have lately been slowing, which should narrow the gap between the two measures.

The market is aware that it is highly unusual for the Fed to cut rates while the economy is producing “solid” growth numbers, even though several economists are predicting a significant downturn in the second half of 2025.

Furthermore, the unpredictable nature of the effect of President-elect Donald Trump’s plans for the economy, including tariffs on imports and the expulsion of undocumented immigrants, should see the Fed act cautiously.

Many market participants will now have great expectations for Jerome Powell’s news conference later today when he provides reasons for the now-likely rate cut and his expectations for monetary policy going forward into 2025.

Meanwhile, the dollar index is being driven as much by growth expectations as it is by monetary policy.

Yesterday, it rose to 107.06 and closed at 106.96. Looking at the spread between its high and low over the past ten sessions, traders are looking forward to next year as opportunities to lose money outweigh the prospect of profits.

As much as a U.S. rate cut today may be unwarranted, the news that several members of the ECB’s Governing Council, even if they are the hawks who were against cutting rates too soon, have called for rates to be lowered moderately and then only to the “neutral level” at which they neither stimulate nor restrict the economy, is hard to understand given the state of the Eurozone’s largest economies and the political turmoil that is threatening to engulf the entire Union.

ECB Board member and “trusted voice” on the economy, Isabel Schnabel was quoted earlier this week as saying that the European Central Bank should cut its key interest rate only gradually while paying close attention to economic data for signs that inflation is reviving.

Schnabel warned against moving too quickly, arguing that there is as much risk that inflation will settle above the ECB’s 2% target as there is that it will level out below.

“We should proceed with caution and remain data-dependent, assessing at each monetary policy meeting whether disinflation remains on track and whether, and to what extent, interest rates remain restrictive,” she said in a speech.

While some ECB policymakers have highlighted the risks to the eurozone’s weak economic recovery from higher U.S. tariffs, Schnabel said much of the impact will take the form of a transitory weakening of confidence.

The use of the term transitory should immediately start alarm bells, given Jerome Powell’s use of this word to describe inflation in late 2021!

When a government falls amid a deepening economic crisis, you might expect the snap elections that follow to offer the opportunity for bold new policies. Perhaps the industrial base will be restructured, or the soaring cost of power will finally be addressed, or there will be a round of deregulation to unleash the wave of start-ups the country desperately needs.

However, in Germany, that is unlikely to happen. When the election takes place in a couple of months, Olaf Scholz’s coalition will be replaced with another “patched up” group with very few ideas of how to solve the economic crisis that the country is currently embroiled in.

Leading contenders in Germany’s upcoming election presented their programs on Tuesday, setting out contrasting visions of how to put new vigour into Europe’s biggest economy and tackle other issues such as migration.

Chancellor Olaf Scholz, a centre-left Social Democrat, will seek a second term in the parliamentary election expected on Feb. 23, a mere three months after his unpopular three-party coalition collapsed in a dispute about how to revive the stagnant economy. He hopes for a come-from-behind victory against centre-right challenger Friedrich Merz, whose Union bloc leads all recent polls.

Also seeking the top job is Vice Chancellor Robert Habeck of the environmentalist Greens, Scholz’s remaining coalition partner. Alice Weidel of the far-right Alternative for Germany is polling strongly, but her route to power is blocked since no other party will work with AfD and an overall majority is out of the question given Germany’s voting rules.

The Euro is either building a strong base around the 1.0480 level or struggling to break through selling interest at 1.0580, depending on your point of view. It is likely to continue to trade between these two levels unless there is a surprise from the FOMC later today.

Yesterday it fell to a low of 1.0479 and closed at 1.0488.

Have a great day!