The Fed Drama Builds: Bank of England Makes Things More Interesting

Includes: AGG, DIA, SPY
by: ContraHour

I don't know about Pig's blog (Pearls Before Swine), but the drama is certainly building in the interest rate arena. While I believe many investors were still hoping for an interest rate cut this year from the Federal Reserve, the Bank of England is signaling that the opposite is probably more likely. And that is weighing on markets across the world.

pearls before swine

The financial headlines Thursday morning all seem to be pointing to the weak retail sales numbers as the catalyst for the steep sell off. However, I think most investors expected the retail numbers to be ugly. First, the Easter Holiday was shifted forward this year making the comparisons very difficult for this month. Second, everyone who's filled up their car knows that gas prices are at all time highs in the US. And finally, the US consumer psyche has been suffering a bit ever since the housing bubble burst and free money doesn't seem to be appearing in the kitchen and bathroom cabinets anymore.

The retail sales probably had a little bit to do with the sell off. But I think the main problem is that the Bank of England raised interest rates this morning to 5.50% when most analysts expected rates to remain steady. Furthermore, the Bank signaled that it is ready to push rates higher next month.

It's clear that the Monetary Policy Committee in England has an agenda to slow England's economy and get inflation under control. The Bank said "The margin of spare capacity in firms appears limited and there are signs that businesses are more able to push through price increases."

But the economy in England only grew 2.8% last year and slowed to 0.7% growth in the first quarter. That's hardly off-the-chart growth that would spur a rate hike. Both numbers are in line or lower than the US. And therein lies the problem.

Inflation has been rising even though growth has been slowing. The yield curve in the UK is dangerously inverted. It almost guarantees a severe slowdown, if not a recession. If you could see the chart below, it shows that the UK yield curve is now inverted by almost 100 basis points. In comparison, the US curve is just slightly inverted but closer to flat. An inverted yield curve is one of the best predictors of an economic slowdown.

UK vs. US yield curve
Charts courtesy Bloomberg

Like the Bank of England, the Fed has said it too is fighting inflation. The Fed's Open Market Committee yesterday said that persistent inflation remains the ``predominant policy concern.'' That's despite the fact that GDP growth in the US came in at a paltry 1.3%.

The reason the US markets are taking this hike by the Bank of England so seriously today is that the Federal Reserve has been trailing the Bank of England in hiking rates. The Bank of England started raising rates in 2003, even though they never lowered rates below 3.5%. The Federal Reserve didn't start raising rates until beginning 2004, and that was from the cellar level of 1.0%.

The Bank of England has been leading...

bank of england rates

The Fed has been following...

fed fund rates

I think the Bank of England just made the markets a bit more interesting. The drama is now building on the interest rate front and the next plot turn will come from Ben Bernake and the Fed.