Era of Low Yields Confronts Central Banks Focused on Inflation
(Bloomberg) -- Investors are girding for a significant leap higher in global bond yields as the dust settles on this week’s glut of central-bank decisions -- it’s just a question of when.
Having set the stage for a more restrictive monetary backdrop over the coming year, investors warn that the present level of bond yields looks too low, should central banks have to up the pace of rate hikes in order to bolster their inflation fighting bona fides.
The Bank of England shocked markets on Thursday with its first hike since 2018, while the European Central Bank reiterated rates would remain low, but raised inflation expectations. That followed the Federal Reserve, which signaled on Wednesday it expects to raise rates three times in 2022.
“We are going to move into a tightening phase, and that is not good for the yields -- it’s not good for the long-end of the curve or the short-end,” said Mark Holman, chief executive officer at TwentyFour Asset Management, a London-based investment firm that specializes in fixed-income securities. “What we will see is a bear flattening. It just needs a bit of time to play out.”
With the latest policy meetings, leading central banks have staked their credibility on fighting inflation, as rising prices trump -- for now -- the threat of further Covid-induced lockdowns. That’s the key message for key sovereign bond markets following this week’s policy meetings.
With the Treasury market prepared for a hawkish Fed, traders unwound popular yield-curve flattening trades in the wake of Powell’s comments. That has spurred a modest decline in policy sensitive yields, while selling has returned to the long end. The 30-year Treasury was little changed at 1.85% as of 6:03 a.m. in London, after briefly rising above 1.9% on Thursday.
‘Behind the Curve’
“I do think Fed is behind the curve,” said Tracy Chen, a portfolio manager at Brandywine Global Investment Management. “They potentially may even have to go faster with hikes. But looking at the forward swap curve shows that some people already pricing in a potential rate cut in two or three of four years. The market is not very confident the economy can handle more hawkishness from the Fed.”
Of course, the Fed hasn’t increased the number of rate hikes it anticipates -- it just pulled the expected dates forward.
Benchmark gilt yields were little changed across the curve on Friday following the BOE’s surprise hike, while traders have nearly fully priced a quarter-percentage point hike to 0.5% at the February meeting.
BOE Will Raise Interest Rates Three Times in 2022, Goldman Says
They also see the central bank’s key rate rising to 1% by August compared with the previous projection of November. According to price action in forwards, interest rates will peak at around 1.125% in the middle of 2023 and then fall around 30 basis points over the following 18 months.
In Europe, the German 30-year yield fell two basis points to minus 0.02%, a day after climbing above zero for the first time since late November.
Money markets kept bets on a first 10-basis-point rate hike by 2023. Should the upside risks to inflation that the ECB is predicting materialize, there’s ample room for money markets to ramp up their wagers on tighter policy.
“The ECB have been forced into this rather uncomfortable policy shift by inflation,” said James Athey, investment director at Aberdeen Asset Management. “Their only task remains keeping bond markets in check long enough to hope the politicians deal with the myriad of structural issues and imbalances in the euro zone. The ECB is therefore trapped.”
In contrast with other central banks, the Bank of Japan flagged on Friday that it would continue its super easy policy amid subdued price gains.
Governor Haruhiko Kuroda said he wants the BOJ to keep aiming for 2% inflation, and tightening moves by other central banks won’t change that. Japan’s benchmark 10-year yield was little changed at 0.045%.
Whether policy makers can keep a handle on bond markets as they tighten policy is the key question for 2022. But it isn’t the only potential fallout from their actions.
“It seems fitting that we end the year looking at inflation and bonds,” wrote Jim Reid, strategist at Deutsche Bank. “If defaults are not an option to de-lever the financial system, a long period of financial repression and negative real returns are likely in order.”
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