Market Update: Markets catching up to reality

After a huge take of borrowing in the early part of 2022 amid the start of rate rises, we got to a high point in October. This was when global activity started to show responses to the rising rate pressure. Subsequently, companies pulled back, only to go on a spurt of borrowing at the start of 2023 and then again during May as bond yields and credit spreads temporarily fell back.

That coincides with the burst of liquidity in markets seen during the following weeks. Now, we know we shouldn’t read too much into such indicators. Other signs from the loan markets and from the wider monetary measures tell us that things have been tighter, especially for smaller firms that have to raise debt through banks. However, we also shouldn’t ignore them. The willingness to borrow suggests that, at least for the larger companies, they are willing to rollover their borrowing at the higher rates rather than try and reduce their debt piles significantly.

This poses a conundrum for the central banks, of course. They were very hopeful that input cost falls would lead to ‘immaculate disinflation’, but the UK experience says it might not happen for them. While the UK’s situation is exacerbated by its own particular issues, there are enough issues in common for the UK data to be salutary for everybody.

That means central banks’ stated bias towards more tightening should be seen as meaning at least one more round of rate rises. Liquidity, which moved up in the second quarter, is likely to be squeezed again through the summer. Against that backdrop, risk markets are unlikely to storm away.

However, despite the many discussions about loss of central bank credibility, long-term real yields (i.e. after subtracting inflation expectations) are stable at around 1%, with long-term market expectations of inflation between 2-2.5% (except for Japan). Meanwhile, credit spreads are at mid-to-lowish levels, thereby indicating few concerns of capital markets about a looming recession. These are indicators of stability and, in central bank terms, success.

We only have to look at Türkiye to see what central bank (and government) failure actually looks like. Following his election victory, Erdogan appointed a new economy tsar, Mehmet Simsek, who has persuaded the president that orthodoxy must be restored. Hopes were that this would mean getting rates up to near inflation levels (currently +40% year-on-year). Rates were raised from 8.5% to 15% on Thursday, and the Türkish Lira slumped another 7% after the 20% decline following the election.

Sterling is not showing such a decline. In fact during the last three months’ inflation surge, sterling has strengthened.

If the resolution to the inflation problem lies in overcoming a structural shortness of labour – and in the UK’s case free trade – then central banks cannot solve it with what’s in their toolkit. Structural, supply-side problems can only be dealt with by far-sighted government policies in conjunction with a discouragement of inflationary demand-side behaviour. Of course, the former takes time and money, and it doesn’t feel like we have a lot of either of those at the moment. Nevertheless, we hopefully have serious politicians with the staying power to see it through. The resilience of sterling and the positive real yields tell us markets are currently giving politicians (and central banks) the benefit of the doubt. However, this does not yet equate to a stable market environment based on the expectation of a return of sustained growth. Such fragile sentiment is therefore easily disturbed by wrong-footed political action or unanticipated data points, as was the case over the past week.