by Mike Dolan
LONDON (Reuters) – Have policymakers and bond markets lost the plot?
As inflation expectations mount, long-term “real” bond yields are dropping below zero, even though G7 central banks are getting tougher in pulling off super-easy pandemic settings, sending markets a scramble to price higher interest rates.
This is not how it is supposed to work, and it will baffle not only investors but also central banks who rely on those very forecasts for critical policy decisions.
The question is whether the bond market is saying something profound — or whether it is as confused as anyone else trying to read about the still deeply distorted post-pandemic economies.
If central banks are indeed expected to tighten much sooner which was contemplated just a few weeks ago, then it is theoretically supposed to rein in investors’ assumptions about future growth and inflation.
There is no doubt that the major central banks have changed course. Their rhetoric now paints a picture of inflationary gains that are still “transient” but have lasted longer, while the moody music speaks volumes about the rising risks that may falter there.
The Bank of Canada this week ended its bond-buying program and raised interest rates, while the Reserve Bank of Australia abruptly stopped intervening to limit borrowing rates in the bond market.
Next week, the Federal Reserve is expected to announce a scaling back of its emergency bond purchase program, and the Bank of England prepares to pull the interest rate trigger.
This quicksand has resulted in a dramatic flattening of the benchmark yield curves, resulting in lower long-term borrowing rates relative to higher short-term yields.
This is often read as a harbinger of credit stress, an economic slowdown, or even a recession ahead.
But there was no commensurate reduction in inflation expectations. If anything, they went up.
So, while nominal borrowing rates up to 30 years have remained low or fallen, real equivalent or inflation-adjusted bond yields have fallen below zero.
Some attribute this to market noise and distractions related to the quick release of the wrong investor position. Earlier this year, under the guidance of those same central banks, many investors suspected that interest rates would rise for 3 years or more.
However, this month’s frenetic money market re-pricing is now planning to raise rates in the UK as soon as next week. Canadian first-quarter rate movement, Fed hike as soon as July as it begins tapering next month; And even a minor adjustment of the European Central Bank as soon as October. [IRPR]
What is behind the macro?
And despite central banks dismissing the claws of the hawks, inflation expectations added at least 0.2% across the G7’s ten-year outlook in October alone, with equivalent real yields dropping to their most negative levels ever except for Japan and Canada.
Break-even rates in the US, UK and Canada derived from inflation-protected bond markets are now above central bank targets and at levels not seen in over a decade.
Eurozone 5-year / 5-year inflation forward swaps were above the ECB’s 2% target for the first time in 5 years, while German 10-year real bond yields fell below -2.0% for the first time this week.
Some see the constellation as a “stagflation” trade in Technicolor – another decade’s pricing bond market modeled after the 1970s of economic stagnation and persistent inflation.
The central bank’s lack of momentum in inflation expectations reflects a structural shift on which credit policies have little bearing – a sweeping reworking of supply chains, a ‘green’ energy shift, policy support to raise long-stagnant wages, and even demographics that limit labor supply. . .
But is this new world conjecture or conviction?
Steve Major, head of fixed income research at HSBC, believes it is inflation expectations that appear “out of sync” in the rising tension between moves in real and nominal bond yields.
“The issue is very important for central banks,” Major wrote. “Should they respond to what the inflation-related markets are telling them – and raise rates now?”
“Or should they take their time, enjoying long bond yields, and weather the bottlenecks and distortions caused by a once-in-a-century global pandemic?”
Charles Diebel, head of fixed income at Mediolanum International Funds, also feels that flattening the yield curve makes a lot of sense, but suspects other anomalies exist.
“It’s very early in the cycle of flattening curves in this way and what that shows is that a lot of the consensus positions have faded away.”
George Saravelos, a strategist at Deutsche Bank, believes that the money market frenzy and some of the biggest one-week moves in the short-term interest rate markets for decades have likely created the kind of financial trading stress that creates other problems.
“What is happening now goes beyond the macroeconomic, it is a clear and simple shock to VaR driven by concentration and the inability to adequately calibrate central bank reaction functions in such an uncertain environment,” he told clients.
“This is as close as we can get to a faltering market.”
Real or imagined? Bond markets may still be just trying to figure all this out. And they will not be alone.
(By Mike Dolan, Twitter: @reutersMikeD. Additional reporting by Sujata Rao; Editing by Alexander Smith)