As inflation expectations mount, long-term ‘real’ bond yields are sinking further below zero, despite G7 central banks turning more hawkish on withdrawing super-easy pandemic settings and sending markets scrambling to price higher interest rates.
That is not how it’s supposed to work and will puzzle not only investors but also the central banks who hinge critical policy decisions on those very expectations.
The question is whether the bond market is saying something profound – or whether it is as befuddled as everyone else trying to read still wildly distorted post-pandemic economies.
If central banks are indeed expected to tighten far sooner that thought only a few weeks ago, that should in theory rein in investor assumptions about future growth and inflation.
There’s little doubt the big central banks have shifted gear. Their rhetoric now sketches a picture of still ‘transient’ inflation gains but sustained for longer, while louder mood music on the rising risks that it might get stuck up there.
This week the Bank of Canada ended its bond buying programme and flagged rate rises, while Australia’s central bank suddenly stopped intervening to cap borrowing rates in its bond market.
Next week, the U.S. Federal Reserve is expected to announce a tapering of its emergency bond buying programme and the Bank of England is poised to pull the interest rate trigger.
Such shifting sands have precipitated a dramatic flattening of benchmark yield curves with has seen long-term borrowing rates slide relative to spiking short-term yields.
This is often read as a harbinger of a credit squeeze, economic slowdown or even recession ahead.
But there’s been no commensurate scaling back of inflation expectations. If anything, they ticked higher.
So, while nominal borrowing rates out to 30 years have stayed low or fallen, equivalent real or inflation-adjusted bond yields have sunk even further below zero.
Some put this down to market noise and skews related to a rapid unwinding of wrongfooted investor positioning. Earlier this year, and guided by those same central banks, many investors doubted policy rates would rise for 3 years or more.
Yet frenetic money market repricing this month now plots a UK hike as soon as next week; a Canadian rate move in the first quarter, Fed liftoff as soon as July as it starts tapering next month; and even a small ECB tweak as soon as October. [IRPR]
‘BEYOND MACRO’?
And despite central banks baring hawkish claws, inflation expectations added at least 0.2% across G7 10-year horizons in October alone as equivalent real yields sank to their most negative ever in all but Japan and Canada.
U.S., British and Canadian ‘breakeven’ rates derived from the inflation-protected bond markets are all now above central bank targets and at levels not seen for well over a decade.
Euro zone 5-year/5-year forward inflation swaps are above the ECB’s 2% target for the first time in 5 years, while 10-year real German Bund yields fell below -2.0% for the first time this week.
Some see the constellation as a ‘stagflation’ trade in technicolour – a bond market pricing a another 1970s-style decade of both economic stagnation and persistent inflation.
And the lack of central bank traction in inflation expectations reflects a structural shift that credit policies have little impact on – a wholesale reworking of supply chains, a ‘green’ energy transformation, political support for lifting long-stagnant wages and even demographics curbing worker supply.
But is that new world a guess or a conviction?
HSBC’s fixed income research chief Steve Major reckons it’s inflation expectations that seem “most out of sync” in the mounting tension between moves in real and nominal bond yields.
“The issue is hugely important for central banks. Should they respond to what the inflation-linked markets are telling them – and raise policy rates now?,” Major wrote.
“Or should they bide their time, take solace in long bond yields, and ride out the bottlenecks and distortions caused by a once-in-a-century global pandemic?”
Charles Diebel, fixed income head at Mediolanum International Funds, also feels yield curve flattening makes most sense but suspects other anomalies.
“It’s very early in the cycle for curves to be flattening this way and what it shows is that a lot of consensus positioning is being washed out.”
Deutsche Bank strategist George Saravelos thinks the money market frenzy and some of the biggest one-week moves in short-term rates markets for decades has likely created the sort of financial trading stress that creates other problems.
“What is happening now runs beyond macro, it is a plain and simple Value at Risk (VaR) shock driven by positioning and the inability to appropriately calibrate central bank reaction functions in such an uncertain environment,” he told clients.
“This is the closest we can get to a distressed market.”
Real or imagined? The bond markets may still be just trying to figure all this out. And they will not be alone.
