Merlin Weekly Macro: A battle of wills on interest rates

At last. Nearly 10 months after the bond markets pre-empted a fall in UK interest rates and were wrong-footed, the Bank of England (BoE) has finally relented and reduced the base interest rate by a quarter-point (0.25%) to 5.0%. Even then it was only by a whisker: a split 5:4 decision by the Monetary Policy Committee (MPC). Concerns remain among policy makers that inflation stickiness in the services sector, still at 5.7%, persists as an underlying problem; it is being assumed that the new inflation-busting wage increases offered by Rachel Reeves to the public sector will not be a direct factor in stimulating upward price pressure in the broad consumer sector.

For short-term borrowers and those who set the price of fixed rate mortgages, the 2-Year UK government bond¹ yield² had already anticipated the likelihood of this first cut, falling below 4% ahead of the announcement. It peaked at 5.4% in July last year, even higher than when Kwasi Kwarteng had his car-crash Budget in October 2022; as we go to press, the yield is 3.72%.

As always, the BoE said that future interest rate decisions will be made on a case-by-case basis, informed by the latest data. That data is innately rearward-looking, whereas monetary policy is attempting to steer future consumption. The strategic direction of monetary policy is determined by where the BoE would like interest rates eventually to settle (if ‘settle’ in this context is appropriate, given the economy is dynamic, is not a command system and is susceptible to external factors); the tactical is how it gets there. Given the split decision on the MPC, it will be interesting to see if the committee now goes for a series of sequential cuts towards a terminal rate or, follows the European Central Bank’s softly-softly pattern when it began its own cutting cycle in June but ducked a second in July despite a return to economic shrinkage in Germany, the eurozone’s biggest economy. Bailey’s caution is evident when he points to not cutting ‘too quickly or too much’; but this is a committee decision, not his alone and there are clear tensions about the future, at least at the tactical level if not the strategic.

The Fed still fencing with the markets

Meanwhile, across the Pond, watching the Federal Reserve (Fed) make its mind up about interest rates is as agonising as watching an eagle fledgling pluck up the courage to leave the nest: lots of flapping, feinting and false starts and trying to look brave before finally taking a deep breath, girding its loins and taking the plunge. Fed Chairman Jay Powell is still at the flapping and feinting stage. But at this week’s Fed policy meeting he took a step closer to the edge, towards that final leap into space to reverse interest rates from 5.5% where they have been since mid-2023.

The Federal Reserve has two elements to its mandate: first, the inflation target of 2% (in fact it is specifically core inflation which excludes volatile food and fuel prices); and second, maintaining full employment. The focus of the past three years has been almost entirely on inflation. While the headline rate of CPI³ is 3%, the core ex-fuel, ex-food rate stayed steady at 2.6% in June. It remains above target but is currently stable. Meanwhile, the latest unemployment data showed a rise in the percentage of people out of work to 4.1%, continuing a slow upward trend since April 2023 when the rate was 3.4%. 4% is what is regarded as a critical finger-in-the-air jobless rate. No free-market economy will ever be at a state of completely full employment in which every person of working age has a job; economists consider a figure that shows less than 4% of people being out of work to be ‘full employment’: what remains are people who are either not seeking employment or are unable to work or are unemployable.

This week, the Federal Reserve was explicit that in its interest rate deliberations it is now placing much more emphasis on the signs of deterioration in the jobs market than it is giving weight to the current above-target inflation rate being of concern. Laden with hints but without actually saying so, Powell allowed markets strongly to infer that he would cut interest rates in September. As we have pointed out on many occasions, interest rates are blunt tools rather than precision instruments when it comes to trying to change consumer behaviour. An interest rate change, either up or down, is a one-size-fits-all blanket policy applied across the whole landscape encompassing the entire range of consumers’ own idiosyncratic economic circumstances; empirical evidence suggests that it takes around two years before the effect of a rate change is measurable on the economy. Having clearly made up his mind that interest rates are going to come down before the end of the year (the markets are pricing in three such cuts before the year-end), rather than finessing the turning point by a month, Powell and his friends might just as well have got on with the job now. But no, one last month of flapping to go before full flight departure. For what it’s worth, the steep fall over the past week in the 10-Year US government bond yield from 4.3% to 3.9% is the market’s slightly careworn exhortation to Powell simply to get on with it and stop messing about.

Phase three in the battle of wills

If all of this seems like a battle of wills, that is precisely what it is. Bond investors are the providers of capital. After two very difficult years including significant impairments or losses for some, they are keen to see returns improve. In terms of capital, that only happens if yields drop (the corollary of which is prices rise); government bond yields only fall sustainably if the benchmark central bank interest rate is perceived to be declining too which in turn is predicated on the outlook for inflation heading back towards the central banks’ common 2% target and remaining stable at that rate thereafter. On the other hand, the central banks who set the benchmark interest rate (i.e. the benchmark cost of capital) are the official authority; their credibility is on the line. It has been sorely tested in the recent significant inflationary hump when they were accused of being asleep at the wheel while inflation was obviously veering off the road; they need to restore that confidence that they know what they are doing.

Even though we have now reached the inflection point in this interest rate cycle, the battle of wills continues. For monetary policy, the post-pandemic period can be divided in to three phases: the first was persuading the central banks that there really was an inflationary problem about which they were being deeply complacent; the second was the tussle about how high interest rates should subsequently go but more critically whether they should peak and immediately reverse or plateau for an extended period. We are now in phase three in which the argument is about how quickly policy is loosened, in essence how fast interest rates come down and to what terminal value.

While the markets tend towards momentum in the direction of bond yields (prosaically, the ‘herd’ mentality), as we discussed in last week’s column it is important to remember that different national economies are neither moving with uniform speed nor in the same direction: in its ‘conversion of growth’ prediction by the International Monetary Fund where it sees major western economies converging on growth rates averaging around 1.5% in 2025, the eurozone and the UK are slowly recovering towards that level while the US is approaching from a different direction and decelerating.

By definition, every central bank has its own national economic interests as its priority; however, in a globalised system, they are very much aware of common problems, complimentary issues and competitive tensions; it is their business to maintain market confidence, an element of which is communicating with each other (as distinct from colluding though in instances of crisis they may certainly coordinate their actions). We may get a better idea of their mid-term thinking on the weekend of August 22-24 when the principal central bankers retire to the fishing resort of Jackson Hole, Wyoming, for a spot of relaxation and to discuss great thoughts on the global economy.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each.  With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.

¹Government bonds are issued by governments.  Bonds are a type of fixed interest investment, in which a company, government or other institution borrows money and, in most cases, pays a fixed level of interest until the date when the loan is due to be repaid.

²The rate of interest or income on an investment, usually expressed as a percentage.

³CPI is the Consumer Price Index, a measure of inflation