Economy is almost certainly in recession and the picture ahead is murky
Let’s start with what we do know.
The economy is now almost certainly in recession. It will not be pleasant. This is a recession which will be felt in most households’ pockets – both through the rise in energy prices and shop prices and the rise in the cost of borrowing.
And when it comes to the cost of borrowing, things are certainly getting tougher. Today the Bank of England raised its official interest rates by 0.75 percentage points, meaning if you’re on a floating rate loan tied to Bank rate the increase will be immediately reflected in your monthly repayments.
In a sense, the Bank is merely doing what most people had expected and what markets had already priced in: in other words, the current fixed rate loans out there on the market already assumed something like this happening.
Remember that point: we’ll come back to it.
So we know the economy is in recession. We know prices are very high and times are looking tough – especially if you have a mortgage which needs to be re-fixed soon. But here’s where the certainty ends and the murkiness begins.
Normally the Bank of England produces one main forecast in its Monetary Policy Report – the quarterly document in which it gives its sense of the state of the economy. But this time around it did something unusual: it produced two, and gave quite a lot of prominence to both of them.
A money market rollercoaster
Why? Well, it comes back to the fact that money markets have been on a rollercoaster recently. As you’ll recall if you’ve followed the ride, in the wake of the mini-budget, expectations for where the Bank’s interest rate was going next year leapt up to over 6%. Since Liz Truss‘s exit, those expected rates have begun to fall, to the extent that as of this week they were expecting a peak of 4.75%. That’s a big change.
And these numbers matter enormously: the higher the rates, the more households who will struggle to make their repayments and the tougher life will get for businesses, many of which will struggle to operate. So even a change of a few fractions of a percentage point will make a big difference.
Eight successive quarters of contraction
That brings us back to the Bank’s latest forecasts. It has to base those forecasts for the state of the economy off an assumption of what’s happening to those interest rates. So it typically takes a two week “snapshot” of what money markets expect for borrowing rates and then builds a forecast around it.
Normally that’s a pretty uncontroversial exercise, but not this time. Because as we all know, those rates were all over the place following the mini-budget and the ensuing gilt market meltdown.
The upshot is that the Bank’s central forecast – the one we usually look at – is particularly bad.
It involves eight successive quarters of contraction: that would be the single longest recession since comparable records began in the early 20th century – though it would be much less deep than nearly all of those downturns. It would see the economy shrink by nearly 3% and unemployment get up to 6.5%.
But here’s the thing: that forecast is based on market expectations that Bank rate would get up to 5.25% next year. And the Bank is unusually explicit today that it thinks that is very unlikely. So that recession forecast is a little bit of a chimera: it is based on a scenario which will probably not happen.
So here’s where that other forecast comes in.
The Bank produced a separate set of figures which ignore all that market mayhem and just imagine rates stay where they are, as of this afternoon, at 3% in perpetuity.
On the basis of that forecast, there is still a recession, but it is barely more than half the depth of its central forecast and doesn’t last half as long. Unemployment doesn’t peak as high. Household income isn’t quite as badly hit. It’s tough, but not awful.
More rate rises
So: is that forecast a more reliable picture of the impending months? Well, not necessarily, for two reasons.
First, the Bank said explicitly today that it thinks it will have to raise interest rates again, albeit not as high as markets were expecting a few weeks ago.
What that means is anyone’s guess, but the signal is that they might not even have to rise as high as the 4.75% markets are currently pricing in. But that does mean a slightly worse outlook.
Second, the Bank’s forecast doesn’t make any assumptions about what the government’s Autumn Statement is going to do to the economy. And given everyone expects the government to cut spending and/or raise taxes, it’s a fair assumption that that could also bear down on economic activity.
It’s complicated
So, as you can see: it’s complicated. I know that’s not especially helpful if you’re after a quick summary. But it’s a fairer reflection of where we are.
The UK is in recession, but it’s worth being a little wary of the more lurid headlines out there about how it’s the “longest in history”. The Bank is saying that’s a possibility if rates went higher (and it doesn’t currently think they will).
But there is another interesting thing going on here, which comes back to that point I made at the start – that when the Bank moves its rates it is, in a sense, reflecting what people out there in the market are expecting it to do. Those expectations matter – and the Bank can often influence them itself.
Today’s Monetary Policy Report contains some pretty heavy hints that the market has overshot its expectations about where Bank rate will go in the future. In other words, the report itself could plausibly persuade investors to notch down their expectations for where interest rates are heading next year.
If that happened, we would be left with an interesting paradox: that even as it raises interest rates even more than it has ever done since it became independent in 1997, the Bank could actually push down what markets expect that eventual peak to be.
In other words, this interest rate increase could be reducing the real-life cost of borrowing in the mortgage markets. Fixed rate loans could get cheaper as a result of today’s events, not more expensive.
Perhaps that sounds topsy-turvy, but then it’s no more weird than many of the other turns of this rollercoaster in recent weeks.
Business
Donald Trump has finally blinked – but it’s not the stock markets that have forced him to act
Chalk this one up to the bond vigilantes.
This is the term used periodically to describe investors who push back against what are perceived to be irresponsible fiscal or monetary policies by selling government bonds, in the process pushing up yields, or implied borrowing costs.
Most of the focus on markets in the wake of Donald Trump’s imposition of tariffs on the rest of the world has, in the last week, been about the calamitous stock market reaction.
This was previously something that was assumed to have been taken seriously by Mr Trump.
During his first term in the White House, the president took the strength of US equities – in particular the S&P 500 – as being a barometer of the success, or otherwise, of his administration.
Donald Trump in the Oval Office today. Pic: Reuters
He had, over the last week, brushed off the sour equity market reaction to his tariffs as being akin to “medicine” that had to be taken to rectify what he perceived as harmful trade imbalances around the world.
But, as ever, it is the bond markets that have forced Mr Trump to blink – and, make no mistake, blink is what he has done.
To begin with, following the imposition of his tariffs – which were justified by some cockamamie mathematics and a spurious equation complete with Greek characters – bond prices rose as equities sold off.
That was not unusual: big sell-offs in equities, such as those seen in 1987 and in 2008, tend to be accompanied by rallies in bonds.
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What it’s like on the New York stock exchange floor
However, this week has seen something altogether different, with equities continuing to crater and US government bonds following suit.
At the beginning of the week yields on 10-year US Treasury bonds, traditionally seen as the safest of safe haven investments, were at 4.00%.
By early yesterday, they had risen to 4.51%, a huge jump by the standards of most investors. This is important.
The 10-year yield helps determine the interest rate on a whole clutch of financial products important to ordinary Americans, including mortgages, car loans and credit card borrowing.
By pushing up the yield on such a security, the bond investors were doing their stuff. It is not over-egging things to say that this was something akin to what Liz Truss and Kwasi Kwarteng experienced when the latter unveiled his mini-budget in October 2022.
And, as with the aftermath to that event, the violent reaction in bonds was caused by forced selling.
Now part of the selling appears to have been down to investors concluding, probably rightly, that Mr Trump’s tariffs would inject a big dose of inflation into the US economy – and inflation is the enemy of all bond investors.
Part of it appears to be due to the fact the US Treasury had on Tuesday suffered the weakest demand in nearly 18 months for $58bn worth of three-year bonds that it was trying to sell.
But in this particular case, the selling appears to have been primarily due to investors, chiefly hedge funds, unwinding what are known as ‘basis trades’ – in simple terms a strategy used to profit from the difference between a bond priced at, say, $100 and a futures contract for that same bond priced at, say, $105.
In ordinary circumstances, a hedge fund might buy the bond at $100 and sell the futures contract at $105 and make a profit when the two prices converge, in what is normally a relatively risk-free trade.
So risk-free, in fact, that hedge funds will ‘leverage’ – or borrow heavily – themselves to maximise potential returns.
The sudden and violent fall in US Treasuries this week reflected the fact that hedge funds were having to close those trades by selling Treasuries.
More from Sky News:
What a global recession would mean
Is there method to the madness?
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Trump freezes tariffs at 10% – except China
Confronted by a potential hike in borrowing costs for millions of American homeowners, consumers and businesses, the White House has decided to rein back its tariffs, rightly so.
It was immediately rewarded by a spectacular rally in equity markets – the Nasdaq enjoyed its second-best-ever day, and its best since 2001, while the S&P 500 enjoyed its third-best session since World War Two – and by a rally in US Treasuries.
The influential Wall Street investment bank Goldman Sachs immediately trimmed its forecast of the probability of a US recession this year from 65% to 45%.
Of course, Mr Trump will not admit he has blinked, claiming last night some investors had got “a little bit yippy, a little bit afraid”.
And it is perfectly possible that markets face more volatile days ahead: the spectre of Mr Trump’s tariffs being reinstated 90 days from now still looms and a full-blown trade war between the US and China is now raging.
But Mr Trump has blinked. The bond vigilantes have brought him to heel. This president, who by his aggressive use of emergency executive powers had appeared to be more powerful than any of his predecessors, will never seem quite so powerful again.
Is there method to the madness? Donald Trump and his acolytes would have you believe so.
The US president is standing firm among all the market chaos.
Just this weekend, after US stock markets suffered their sharpest falls since the onset of the pandemic, Trump reposted a video on his social media platform Truth Social. This was its title: “Trump is purposefully CRASHING the market.”
Tariffs latest: ‘BE COOL’, Trump says as trade war escalates
The video claimed the president was engineering a flight to US government bonds, also known as treasuries – a safe haven in turbulent times. The video suggested Trump was deliberately throwing the stock market into chaos so investors would take their money out and buy bonds instead.
Why? Because demand for treasuries pushes up the price of the bonds, and that, in turn, lowers the yield on those bonds.
The yield is the interest rate on the debt, so a lower yield pushes down government borrowing costs. That would provide some relief for a government that has $9.2trn of government debt to refinance this year. Consumers also stand to benefit as the US Federal Reserve, the US central bank, would likely follow suit, feeling the pressure to cut interest rates.
A trader works on the floor at the New York Stock Exchange. Pic: Reuters
Trump and his treasury secretary, Scott Bessent, have made it a key policy priority to lower yields. For a while, it looked like the plan was working. As stock markets tumbled in response to Trump’s tariffs agenda, investors ploughed their money into bonds instead.
However, Trump may have spoken too soon. On Monday, the markets had a change of heart and rapidly started selling government bonds. Thirty-year treasury yields hit 4.92% on Wednesday, their biggest three-day jump since 1982. That means government borrowing costs are rising – and not just in the US. The sell-off has spiralled to government bonds worldwide.
Rachel Reeves will be watching anxiously. Yields on Britain’s 30-year government bonds, also known as gilts, hit their highest level since May 1998. They registered a 27 basis point jump to 5.642% today – that’s on track to be the largest one-day move since the aftermath of former prime minister Liz Truss’ “mini-budget” in October 2022.
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‘These countries are dying to make a deal’
This is a big deal. It is the sharpest sell-off in the US bond market since the pandemic. Back then, investors also rushed into bonds before dumping them and the motivations, on one level, are similar.
In 2020, investors sold bonds because they had to cover losses elsewhere in their portfolios. When markets fall, as they have done over the past few days, lenders can demand that an investor who has borrowed money stump up more cash against the value of their loan because the collateral against those loans has fallen in value. This is known as a “margin call”. Government bonds are easy to sell as investors “dash for cash”.
There are signs that this may be happening again and central banks, which had to step in last time, are alert.
The Bank of England warned today of the growing risks to financial stability. “A sharp increase in government bond yields could crystallise relatively quickly,” it said.
There are other forces weighing on government bonds. With policy uncertainty unfolding in the US, investors could also be signalling that US debt isn’t the safe haven it once was. That loss of confidence also seems to have hurt the dollar, one of the world’s safest places to park your money. It’s had a turbulent journey but is down 1.15% against a basket of safe haven currencies since Trump announced widespread tariffs on 2 April.
Some are even wondering if China could be behind some of this, dumping US government debt as a revenge tactic to hurt a president who has explicitly said he wants bond yields to come down. The country holds $761bn of US government bonds, second only to Japan. If this is the case, then the US-China trade war could rapidly be evolving into a financial war.
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