When good news is bad news

10 July 2023

Data released last Thursday showed a bumper rise in private sector job creation in the US, highlighting the strength of the wider economy. Rather than treating this as good news, equity markets fell on fears that a strong job market would push interest rates higher, adding to the risk of a hard landing. Last week the yield, or interest rate on two-year US government bonds – which reflects interest rate expectations – briefly reached the highest level since 2007.

In the last three months financial market expectations for interest rates have also risen sharply in the euro area and the UK. The German bond market is assuming that interest rates in the euro area, which currently stand at 3.5%, will stay around current levels for the next two years, signalling the tightest European credit conditions since the eve of the financial crisis.

The UK has seen the sharpest rise in interest rate expectations. Since April interest rates on two-year UK bonds have risen by 210 bps, compared with a 90bps increase in US yields and a 70bps rise in German yields. Markets now assume that UK base rates, which have risen from a low of 0.15% in late 2021 to 5.0% today, will peak at about 6.25% early next year, far higher than the expected peaks for the US and the euro area (5.5% and 4.0%, respectively).

In the US, Germany and the UK good news in the form of low unemployment and better wage growth has translated into bad news in the form of higher interest rates.

Financial markets see the UK facing a higher peak in rates than elsewhere because inflation risks appear to be greater. UK headline inflation has fallen less than in the US and the euro area since the start of the year and core inflation, which has moderated in the US and the euro, has reached a 30-year high. Markets are uneasy with US wage growth of 4.4% but perturbed by wage growth of 6.6% in the UK.

We cannot take market views on rates at face value. Rate expectations are volatile, shifting with changing data and central bank rhetoric. If UK inflation and activity data weaken more markedly than expected, rate expectations will probably fall back too. In March US two-year bond yields dropped by over 125bps in the space of less than a fortnight for exactly this reason.

Weakness in the UK labour market, especially wages, would bring rate expectations down, bringing relief to households facing five-year mortgage rates that are now over 6.0%. Paradoxically, bad news in the real economy would be good news for borrowers.

For the latest charts and data on health and economics, visit our Economics Monitor:
https://www2.deloitte.com/uk/en/pages/finance/articles/covid-19-economics-monitor.html

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index closed the week down 2.5% at 7,265 as investors increased their expectations for future interest rates.

Economics

The UK government sold £4bn of two-year government bonds at 5.7%, the highest yield since the UK Debt Management Office was established in 1998
Markets interpreted Bank of England governor Andrew Bailey’s comments as hawkish when he said that he wanted to get inflation “back to where it needs to be and then we can assess what level interest rates should be at going forward”
The average rate on five-year fixed-term mortgages in the UK jumped to over 6%, according to data provider Moneyfacts
UK house prices fell by 2.6% in June compared with a year earlier, the steepest annual decline since 2011, according to Halifax
UK supermarket Sainsbury’s said that food price inflation is “starting to fall”, adding that prices on its top-100 selling products are now lower than they were in March
Half of individuals over-50 who retired in 2020-21 are now living in relative poverty, according to the Institute for Fiscal Studies, as many people retired early due to the disruption and health risks caused by the pandemic
Euro area house prices fell 0.9% in the second quarter compared with the same period a year earlier, the second consecutive quarterly decline with Germany and Sweden seeing the steepest falls
Euro area producer price inflation turned negative in May for the first time since the pandemic, driven by lower energy costs
European vice president Luis de Guindos said that “while underlying price pressures remain strong, most indicators have started to show some signs of softening”
US borrowing costs hit a 16-year high after the US Federal Reserve signalled that it would resume rate rises due to a “tight” labour market and “upside risks” to inflation
US manufacturing activity contracted for the eighth consecutive month in June, hitting a three-year low as weaker demand squeezes production
Saudi Arabia and Russia, the world’s largest oil exporters, deepened production cuts to boost flagging prices
China service sector growth slowed in June, adding to other disappointing data that suggests the economic recovery is stuttering

Business

The UK’s financial watchdog summoned bank chief executives to address concerns that savings rates have not increased as quickly as lending rates
The UK water regulator announced that it expects companies may need to raise prices from 2025 to fund investment and pay for environmental improvements
The Competition and Markets Authority warned that weakening competition between petrol stations was increasing consumer prices
Meta chief Mark Zuckerberg said that 30m people had signed up to Threads, its newly released competitor to Twitter
Household appliance retailer Currys said sales of smart speakers had “fallen off a cliff” as consumers cut back due to the cost of living crisis
Electrical retailer AO World said that inflationary pressures had levelled out as shipping prices and supply chains have normalised

Global and political developments

NATO extended Jens Stoltenberg’s term as secretary-general for another year, deciding against a change in leadership amid the war in Ukraine
The World Bank estimates that nearly a quarter of Ukrainians are living in poverty and 20% of household are reliant on humanitarian assistance
The FT reported that Chinese president Xi Jinping warned Vladimir Putin against using nuclear weapons in Ukraine when they met earlier this year
Iran became the latest member of the Shanghai Cooperation Organisation, an economic and security union led by Russia and China
US treasury secretary Janet Yellen travelled to Beijing to meet high-ranking officials in an attempt to stabilise strained relations between the world’s two largest economies

And finally… hundreds of divers and snorkelers attended an underwater music concert in Florida Keys, aimed at highlighting coral reef protection. The concert involved people swimming along Looe Key’s marine life and coral formations while listening to music - dive bar

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