Source: Bloomberg, Federal Reserve Bank of New York
Further detail regarding the term premium can be found here
The IMF’s Financial Stability Report alluded to the risk of higher inflation – without saying that it would happen – that could push rates up and increase the premium. Indeed, this is a valid issue to focus on now, for at this junction, one of the important issues is where are we in the economic cycle? After a period of strong global growth, with low inflation, the pick-up in demand and tightening labour markets mean we need to monitor closely potential inflation pressures. Indeed, one such example, oil prices are firm. Moreover, the Fed’s hiking is partially aimed at keeping inflation pressures at bay.
Will they, won’t they? May UK rate hike remains uncertain
Here in the UK, meanwhile, inflation is decelerating and – as we have highlighted – we expect it to fall further as the year progresses. The pass through of the post Brexit Referendum devaluation of the pound has fed through into inflation measures, just as it did when sterling fell sharply after the financial crisis. Now, as then, domestic inflation pressures have remained subdued, allowing headline inflation to decelerate. While we need to be vigilant, as wages are creeping up in the UK, the annual rate of inflation still looks set to fall.
This brings us back to the debt picture. When the Bank of England considers whether to raise interest rates in May – at the time of its next quarterly Inflation Report – it will need to factor into its thinking an analysis of how the economy will cope. Will borrowers be able to bear the strain of higher rates? If rate hikes are gradual then they might. Last week Governor Carney indicated that recent mixed economic data implies that a hike is by no means certain. And after weak growth (albeit weather related) in the first quarter and decelerating inflation, one can understand why there is a case for waiting. That being said, a hike in May still seems more likely than not.
Positive news for UK government debt
Meanwhile, market attention is also focused on the UK Government debt picture. Here the news is good – as we have been suggesting it would be – and better than the market has been expecting. Steady growth, low rates and yields are helping the UK’s debt dynamics.
This week, data showed that the Government has achieved its first budget surplus on current spending since 2002. Admittedly the Government is still borrowing a sizeable amount – with the budget deficit for the fiscal year 2017-18 reaching £42.6 billion. This is £2.6 billion below the forecast made only last month by the independent Office for Budget Responsibility. Their forecast for this fiscal year is £37.1 billion, but I think the eventual outcome in a year’s time could be far less. Of course, as the year progresses, the Chancellor may come under pressure to spend more, particularly to ease the pressure on some areas such as local authority spending.
So, as we approach the tenth anniversary of the financial crisis in September, part of the market’s attention will be how that macroeconomic paradox unfolds. For now, the markets are hoping that gradual and predictable UK monetary policy tightening will be able to go hand in hand with improving debt dynamics.
If it was my decision, I would be tempted to leave rates on hold in May, as inflation is falling, growth is sluggish and sterling has recently strengthened. I still think a weak pound is good news for the economy. But, despite Governor Carney’s recent comments, a hike is still possible in May and November, as we have previously indicated. The markets can cope with this. Moreover, as the year progresses, the budget deficit will fall further, proving further good news.