Active Thinking

At GAM Investments’ latest Active Thinking forum, Adrian Owens discussed his expectations for inflation and monetary policy over the remainder of the year, with a focus on the US, Japan and the UK.

26 October 2022

Over the last three months, treasury yields have risen consistently. Deutsche Bank highlighted that we have now seen 12 consecutive weekly rises in 10-year treasury rates, which is the longest run since Paul Volcker was Chair of the Federal Reserve (Fed) in the mid-1980s. We are now at a point where markets believe the Fed will increase rates to just below 5% by May 2023, after which the consensus is it will very gradually reduce them. This marks a significant change from the prior belief that rates would go up and then come back down very quickly. We have consistently held the view that inflation will not just go away. With that said, as investors, we must acknowledge that the market is now pricing more tightening and tighter for longer.

Markets and investors are constantly looking for a turn in the cycle and a signal to start buying traditional asset classes again. We do not think we are at that point yet. Recent commentary suggests that the Fed is likely to increase rates by 75 bps next week but is likely to at least begin to discuss the possibility of being less aggressive in December. In many ways this is logical because financial conditions have significantly tightened – equities are lower, mortgage rates have increased and the leading economic indicators suggest that the US housing market will be much weaker going forward. These factors take time to impact on the economy though and although they will negatively impact the consumer, we must remember that the main driver of consumption is wages; the labour market remains very strong. The US JOLTs survey is very forward looking and the last report shows that the number of job openings relative to unemployment is not as stretched as it was. Job openings are slightly decreasing but they need to come down a lot further, in our view. Many of the other indicators of the labour market, such as jobless claims or the unemployment rate itself, are still suggesting that the labour market is very strong. As long as this remains the case, wages are likely to remain firm. As a result, we think consumption will remain reasonably solid and core inflation, at least for the next few months, is likely to move higher.

In the background, we may start to see headline inflation come down a little. Indeed, some of the leading indicators suggest it may have already peaked. We therefore believe that over the next few months we are likely to move into no man’s land, meaning markets will focus on the fact that headline inflation may have peaked while data is likely to show that growth remains reasonably solid, unemployment is still very low and core inflation continues to move higher.

Looking outside the US, Japan has been in focus of late given the weakness in its currency. For a long time, people thought that neither the Swiss National Bank nor the European Central Bank would raise rates, but both have. The Bank of Japan (BoJ) therefore remains the one major central bank that refuses to take action on interest rates. For as long as that remains the case, we believe the yen will remain under pressure. Inflation in Japan is now up to around 3%, so pressure continues to grow on the BoJ to step away from yield curve control, though little is priced into markets at present.

With regard to the UK, it is best to look at sterling against a basket of currencies, or in particular, against the euro given the dollar is strong against all currencies. In the context of sterling against the euro, sterling has not moved a huge amount. Where the aftermath of the Truss government played out was in the gilt market. UK interest rates underperformed almost all other markets during that period, largely as a result of plans to implement unfunded tax cuts at a time of high inflation. Arguably, given how reluctant the Bank of England has been to raise interest rates, conditions in the UK were primed for weakness in interest rates prior to the mini budget. Newly appointed Prime Minister Rishi Sunak recognises that inflation is the UK’s biggest problem and his policies are likely to be more restrictive in terms of what they mean for economic growth. Sunak will make sure any medium-term funding is in place for the UK, which is positive, but the market is likely to remain cognisant that a general election may not be too far away.