Stubborn UK wage growth weighs on rate cut hopes, as European stocks suffer heavy falls

The UK labour market data did not deliver the news that the market was expecting. Wage growth failed to moderate as expected, with headline wages remaining at 5.6%, and wages excluding bonuses falling back a notch to 6%, the market had expected a deeper decline to 5.8%. The labour market data was a mixed bag, the unemployment rate ticked up to 4.2% from 3.8%, and the estimate of March payrolled employees fell by 67,000, although this figure is subject to change according to the ONS.

Digging deeper into the ONS data tells you that the number of job vacancies fell in the first quarter of this year by 13,000 to 916,000, this is still a high number, but it may be a sign that the demand for labour might be slowing down from exceptionally high levels. 106,000 work days were lost in February because of strike action, with the most days lost in the health and social work industry. This is roughly in line with recent trends, so it should not impact GDP growth.

Real wage growth could boost the UK consumer

While nominal wage growth was stronger than expected, it has backed away from recent highs. Earnings ex. bonus had been as high as 8% in the middle of last year, so there still is a disinflation trend in wage data. However, real wage data, when adjusted for inflation, is rising. Real wage growth, which measures wage growth minus the CPI rate, was 2.6%, the highest level since November. This could rise further depending on whether inflation fell back as expected last month.

Structural shifts in the UK labour market hinders the prospect of rate cuts for the BoE

Although the number of payrolled employees fell back in the three months to February, the total number of payrolled employees is well above pre pandemic levels and is higher by 1.249 million since 2020. However, the labour market picture in the UK is complicated by a fall in the employment rate, which fell by 156,000 in the three months to February, and is down by 0.5% on the quarter, and lower by 1.7% since 2020. The inactivity rate is also on the rise. It rose in the quarter by 0.3%, and by 1.7% since 2020, and is still higher than pre pandemic levels.

The decline in the number of employed people in the UK is turning into a structural issue that will lead to 1, more immigration to fill the large number of outstanding vacancies and 2, continued upward pressure on wages. The inactivity rate is also looking like a structural shift and one that cannot be easily fixed.

Why the BoE may not cut rates until the Autumn

The question for investors is, does this shift the dial for the Bank of England? On the back of this data, the market is now not expecting the first rate cut to come until August. Stubborn wage growth has reduced the chance of a June rate cut. We expect the BOE to use the structural shift in the UK labour market as a powerful reason why they need to pursue rate cuts in a cautious manner. 2-year Gilt yields could move higher on the back of this datal, and we could see it further weigh on risk sentiment. It has lent some support to GBP and GBP/USD has found support above $1.24 for now. Reduced rate cut expectations could do the following things to sterling assets: 1, weigh on Gilts, and push yields (and mortgage rates) higher, 2, support sterling, which may be one of the better performers vs. the USD in the short term, and 3, further reduce the number of rate cuts expected from the BOE this year. Currently there is 1 rate cut fully priced in and a high chance of a second cut. We think that the prospect of a second cut is now less likely. Expectations of UK interest rates in 5 years’ time has been moving higher and is now back above 4% at 4.13%, according to the Sonia curve. Structural shifts in the labour market are one reason why the market thinks that higher rates in the UK are here for the long term.  

The FX view: Rampaging Dollar hurts EM

The dollar is on the rampage right now as a mix of safe haven flows and a reduced chance of Fed rate cuts make the greenback a formidable force in the FX space. EM currencies have crumpled overnight, leading to intervention in the EM FX space. The dollar is higher vs. the Indonesian Rupiah by nearly 2% since Friday, which led to officials in Indonesia intervening in the FX market to prop up their currency. The South Korean won is also lower by nearly 1.4% vs. the USD in the past few days. The Indian rupee is at a record low vs. the USD. The prospect of intervention to support EM currencies, is extremely high, which could boost volatility in the FX market. The elevated oil price combined with the strong dollar raises the specter of inflation in the emerging world. As we have said in previous notes, reduced expectations of rate cuts from the Fed is unlikely to break something in the US economy, but it could break something in the EM world.

Asian stock market weakness takes cue from US

Overnight, Asian stock markets tanked on the back of mixed China data, which does not bode well for future growth, heightened Iran/ Israel tensions, as Israel weighs up its response to Iran’s drone and missile attacks, and a surge in US government bond yields, which rose sharply on the back of stronger US retail sales data on Monday. The 2-year yield tested the 5% level, however, it backed away from that level late on Monday. Safe haven flows on Tuesday could boost Treasuries and weigh on yields later today.

Israel/Iran risks mount

Elsewhere, the initial muted response to Iran’s drone and missile attack on Israel has shifted. The market is back to being worried about the consequences. The brent crude oil price is back above $90 per barrel and is higher by 0.2% so far on Tuesday. The gold price made another record high on Monday at $2,383. It is lower on Tuesday, however, the recent surge in the gold price has been driven by sovereign and central bank buying, while flows into gold ETF’s have bene negative. With increased geopolitical risk, this could turn positive, and we may see flows into gold ETF’s start to rise again. If this happens, then the price of gold could move higher towards $2,500 per ounce.

A trifecta of risks for financial markets

Overall, there is a trifecta of risks for financial markets to digest on Tuesday: 1, a greater chance of a retaliatory strike by Israel on Iran, 2, the chance of the next move from the Fed being a rate hike not a cut and 3, a weakened China and more volatility in the FX space. This is why European stock markets have opened deeply in the red with the FTSE 100 down more than 1.2%.