Followers of financial markets are by now very familiar with two words: “inflation” and “transitory.” Inflation is all over the headlines as prices of commodities, goods and services surge globally. And assurances that it is transitory have become the standard central bank narrative.
It is therefore notable that, as investors finally began to price mounting inflation concerns into their central bank policy rate expectations, they met with surprisingly little pushback from the policymakers themselves. Some Anglosphere central banks even appeared to confirm these worries with a more hawkish tone.
The result has been a spike in volatility at the front end of worldwide rate curves—and a growing sense that the “transitory” narrative is being abandoned and central banks are emerging from their pandemic-era hibernation.
Sticking to the Script?
Policymakers have spent the year predicting that inflation would decay as the base effects from last year’s pandemic crisis dissipated. But the economy didn’t get the memo, and fixed income and rates investors have responded.
At one point recently, the U.S. rates market went from pricing in zero rates hikes before the end of 2022 to pricing in two full hikes, with the first expected immediately after the end of asset-purchase tapering in June next year.
How have policymakers reacted?
Among major rate setters, only the European Central Bank appears to have stuck to the script. Its latest commentary forcefully supported the transitory-inflation narrative and subtly pushed back against the market, suggesting that more aggressive pricing would not be consistent with the ECB’s projection and forward guidance, which it regards as a clear articulation of the key eurozone inflation conditions that need to be met before an initial rate hike. Investors responded by pushing rates up still further.
At last week’s meeting and press conference, the Federal Open Market Committee did attempt to separate the tapering and “lift-off” decisions to give itself maximum optionality in future decision-making, and to redefine maximum employment to include a recovery in the labor force participation rate, which has lagged the unemployment rate. Unlike the ECB, however, it conspicuously declined to comment on rapidly shifting market rate expectations or set a path for those expectations.
Spikes at the front end of the ex-U.S. Anglosphere rate curves were even more amplified—to some extent, these were the shocks that reverberated through the U.S. and European market.
Bank of England Governor Andrew Bailey had been making very hawkish noises in response to acute inflationary pressures in the U.K., leading markets to price in as many as four to five rate hikes over the next 12 months. On Thursday, however, he flinched, delaying lift-off until at least December 16. Investors immediately revised their expectations down to three or four hikes.
The picture is much clearer in New Zealand, Canada and Australia.
After the Reserve Bank New Zealand put in its first post-pandemic hike of 25 basis points in early October, taking its policy rate to 0.5%, the market proceeded to price in seven more hikes over the next 12 months.
The Bank of Canada abruptly ended its quantitative easing program two weeks ago while maintaining forward guidance of a mid-2022 rate hike. But the market adjusted expectations to an immediate lift-off, pricing in four hikes for the next 12 months and five to six hikes before the end of 2022.
In Australia, after inflation broke the upper bound of the Reserve Bank of Australia’s (RBA) 2 – 3% target, investors pushed front-end yields relentlessly higher—and the RBA responded by immediately abandoning its yield curve control policy on the three-year part of the curve. Current market expectations discount rate normalization to 2% over the next two years.
Out of the Deep Freeze
Overall, investors are left with a sense that central banks are finally emerging from hibernation, during which they loosened policy as much as they could and then stepped back.
Asset-purchase programs are starting to wind down at all the major central banks, and some have been surprisingly acquiescent in the face of market assertiveness on rate expectations. There is a change in the inflation narrative, although some policymakers appear reluctant to let go of the transitory story.
As we discussed in our recent Fixed Income Investment Outlook, this is likely to lead to persistent interest rate volatility, and higher risk premiums, as investors look for more clarity on tapering, lift-off and forward policy expectations from the various central bank meetings. As well as trading opportunities, this volatility could open opportunities for carry and rolldown return at the front end of rate curves.
Rates markets—and rate setters—may be coming out of the deep freeze at long last.
In Case You Missed It
- ISM Manufacturing Index: -0.3 to 60.8 in October
- ISM Non-Manufacturing Index: +4.8 to 66.7 in October
- Federal Open Market Committee meeting: The FOMC made no changes to its policy stance
- U.S. Initial Jobless Claims: +269,000 for the week ending October 30
- U.S. Employment Report: Nonfarm payrolls increased 531,000 and the unemployment rate decreased to 4.6% in October
What to Watch For
- Tuesday, November 9:
- U.S. Producer Price Index
- Wednesday, November 10:
- U.S. Consumer Price Index
- U.S. Initial Jobless Claims
– Andrew White, Investment Strategy Group