MARKETS WAKE UP TO CHANGING OUTLOOKS FROM CENTRAL BANKS

This week we saw markets respond to higher inflation and the changing outlook from central banks. It took several days for last week’s interest rate meetings to filter through, but the imminent arrival of tapering and the real potential for early interest rate hikes has meant a choppy few days for markets, with bonds in particular feeling the effect. Central banks are concerned about inflation, and they want to be seen to be concerned about inflation. But as a lot of current inflation is being driven by supply bottlenecks interest rate hikes will be largely ineffective. For example, the current surge in gas prices would have happened even with higher interest rates.

Against this, central banks need to consider the effect of a rate hike on consumer behaviour just as central government employment support is being removed. With so much of the recovery depending on consumers returning to their pre-pandemic, free-spending ways there is an all-too- real risk that central banks could increase interest rates too fast and choke off the recovery before it has really begun.

GLOBAL: BOND YIELDS RISE AS MARKETS ADJUST TO INTEREST OUTLOOK

Bond and equity markets fell this week as markets began to adjust to the changing outlook for monetary policy on both sides of the Atlantic. Markets were unmoved after the round of central bank interest rate meetings last week. However, clarifying comments from central bank governors and fears of a US government shutdown have seen money flow out of government bonds, driving yields higher.

Gilts saw some of the biggest losses as 10-year yields increased from 0.8% at the start of the week to 1.07%. This is the first time 10-year gilt yields have exceeded 1% since March 2020. The increase in government bond yields has also knocked the value of highly valued growth companies, particularly US technology stocks. This has dragged on the wider US equity market and the S&P 500 ended the month down around 4.7%. The potential for US interest rates to rise sooner than expected has seen the value of the US dollar appreciate substantially this week.

UK: BOE SAYS END OF FURLOUGH IS KEY TO INFLATION OUTLOOK

The government’s furlough scheme came to an end with an estimated 1 million employees still supported by the scheme. Speaking earlier this week, Bank of England governor Andrew Bailey said employment would be a key factor in the timing of any interest rate increase as the uncertainty surrounding UK employment would be resolved shortly. The big question is whether furloughed employees will be able to fill some of the record number of job vacancies and prevent wage inflation.

The outlook for employment will also have an impact on consumer spending. This week saw UK Q2 GDP growth revised up from 4.8% to 5.5%, partly due to stronger than expected consumer spending. The majority of roles still on furlough are lower skilled jobs where employees tend to spend rather than save their earnings. A substantial increase in unemployment would see consumer spending fall but could also see wage inflation if employers struggle to attract staff.

ENERGY: HIGH PRICES COULD DRAG ON ECONOMIC GROWTH

Three more UK energy suppliers collapsed this week as a shortage of supply, low inventory levels and a big increase in global demand continue to drive the price of natural gas higher. The spike in gas prices has also helped push the price of oil past $80 for the first time since 2018, further complicating the outlook for inflation.

It is not just oil and gas prices which are spiralling. Coal has also seen rapid price rises, with the price per ton soaring from $59 a ton to $212 a ton in the space of a year. This has been caused by China scaling back domestic production in anticipation of less demand due to tougher emissions targets. Supply bottlenecks and other countries bringing coal-fired power stations back online in the face of rising gas prices are also contributing. China is dependent on coal to generate most of its electricity, but the high price of coal and lack of supply has begun to affect its electricity supply and this is starting to impact factory production and expectations for GDP growth are being revised down further.