After the almost linear rise in bond yields since the beginning of August, the Bank of England’s intervention to save some UK pension funds restarted another pivot talk which coupled with several bad economic data released this week and low liquidity resulted in a dramatical drop in yields across the globe. In this brief article, we are looking at recent events and analyzing whether we could see another prolonged bond-buying period as we saw in the summer.
This year we have seen two bond rallies and markets are questioning whether we are now in the midst of the third one. The first one was due to risk-off driven by Russian aggression on Ukraine, but investors rather quickly realized that inflation would continue creeping higher backed up by skyrocketing commodity prices. Another rally started at the beginning of summer after a significant drop in bond prices and lasted for almost two months. The rally was driven by recession and pivot talks but also by low liquidity in the summer months. In the mentioned period bund yield went from 1.92% to 0.70% while the yield on 2Y German paper went to almost zero from 1.2%. Nevertheless, during the summer, economic data was rather mixed while inflation continued higher and central bankers showed that they will focus on inflation even in the case of modest recession. In its September meeting, ECB showed its hawkish side by lifting the rates by 75bps and even mentioning QT which is to be discussed these days in their non-monetary meeting. On top of inflation worries, a mixed economic picture, and now very hawkish central banks around the world, UK’s plans to cut taxes to support its economy made the perfect storm for UK’s assets. Namely, the 10Y GILT yield went from 1.75% in early August to slightly above 3.0% in mid-September and then shot up to 4.50% in just one week. As bond markets around the developed world have a correlation close to one another, yields skyrocketed in US and Europe simultaneously. However, as my colleague Ivan wrote in his last week’s piece, several UK pension funds had difficulties with liquidity which prompted BoE to step into the bond market with temporary QE worth some £65bn (pouring them in long-dated gilts within two weeks).
BoE intervened on Wednesday and saved UK’s financial institutions but still it intends to exit from this temporary QE on October 14th and then start with QT on November 1st. This move should be seen as a quick fix in respect of financial stability rather than a monetary policy tool and it is to be seen what will happen with the cash market once the BoE is out. In any case, this is also the first victim of the aggressive tightening of central banks. On top of that, during the weekend there were some stories that Credit Suisse has some difficulties but still, it is not clear what were the drivers of the story besides the drop in the stock price and rise of CDS on the bank. You can imagine the feeling across the globe once investors think about a big bank failing (zeitgeist on September 18th, 2008). Furthermore, in the first two working days of October, we saw a strong fall in the US JOLTS versus the previous month and ISM fell across the sectors. Summing up all the above news, one should not be surprised that we have seen bond yields dropping like a rock, but these moves that we have seen were really something. From their peak, bund yield fell by 50bps while BTPS yield fell by 75bps. Gilts’ yields dropped way more on the BoE and the news that UK’s newly appointed PM will try to lower UK’s debt.
So, where do we stand now? It is obvious that an aggressive hike in central banks’ rates will have some consequences for the real economy, and we saw the first ones. However, it is still to be seen whether central banks will be eager to pivot quickly as they did in 2022. We think that they will be able to pause and go on autopilot for some time and that is the optimistic scenario in which inflation is falling constantly due to lower demand in a recession. More likely we will see more of these changes in narrative and increased volatility in rates.
Chart. US Inflation and Fed Funds Rate
Source: Bloomberg, InterCapital
Producer prices of industrial products on the domestic market grew by 30.2% YoY and 3% MoM in September 2022. As expected, the growth in the Energy segment was still by far the largest driver, and if we were to exclude it from the calculation, the growth would amount to 11.5% YoY and 0.7% MoM.
The Croatian Bureau of Statistics (DZS) has published a monthly report on the changes and developments recorded by the industrial sector, and in particular, the industrial producer prices. In the report, we can see that the producer prices of industrial products on the domestic market increased by 30.2% YoY, and 3% MoM. Energy still remains the main driver of this growth, and if we were to exclude it from the producer prices, then the growth would be 11.5% YoY, and 0.7% MoM.
As the current geopolitical situation around the world is putting a lot of pressure on prices, especially commodities (gas and oil in particular) and by extension, energy prices, the trend of growth in producer prices is still unlikely to stop. Considering this is only one factor that is influencing this, with wider inflationary pressures from the supply chain disruptions that we witnessed in the last year – year and a half, combined with the ever-growing recession fears, again, the trend of growth is unlikely to stop, as none of these issues have a permanent solution on the horizon.
If we were to look at the producer prices growth by segments, on an MoM basis, prices in Energy increased by 7.9%, in Durable consumer goods by 2.2%, in Non-durable goods by 0.9%, in Intermediate goods by 0.6%, while in Capital goods, a 0.1% decline in prices was recorded. However, if we were to look at the YoY price change, the picture is a lot more profound. PPI in the Energy segment increased by 81.5%, in Durable goods by 13.5%, in Non-durable consumer goods by 13.2%, in Intermediate goods by 11.3%, and in Capital goods by 5.7%.
Meanwhile, looking at the producer price change by sectors, prices in Mining and quarrying grew by 135.8% YoY, in Electricity, gas, steam, and air conditioning supply by 59.7%, and in Manufacturing by 16.6%.
Producer prices of industrial products (June 2016 – September 2022, YoY, %)
What is also interesting is the fact that the prices have partially spilled over to segments other than energy. Even though the prices in the Energy segment have increased the most, by far, if we look at other sectors, we can see prices increasing as well. Of course, all industry requires energy to operate, so a prolonged period of higher energy will have spillover effects. Also considering that supply chains have been really strained for the majority of 2021 and the majority of 2022 as well. Combined with the sanctions against Russia and the war in Ukraine, both of which are having an impact on a lot of exports from these countries. Exports of oil, gas, wheat, precious metals, but also fertilizers in Russia’s case, and wheat, sunflower, and several precious metals and gases in Ukraine’s case are lacking and this puts even higher pressure on the supply. The fact that China has strict COVID-19 policies in place is also putting a strain on the global supply, as the country is at the same time one of the largest exporters of certain products (precious metals, food), but also one of the largest importers of other commodities, primarily oil and gas. All of these factors combined are among the few of challenges that are unlikely to get fixed in near future. As such, it’s extremely hard to predict how will these prices change, as all of these factors are also increasing the likelihood of a recession.