Global yield curves have been trending toward historic levels of flatness as market participants pull expectations for interest rate hikes into the front end of yield curves. The aftermath of a unique pandemic-driven recession has led to persistent inflationary pressures, lagging labor force participation, and supply-chain constraints, forcing central banks to consider interest rate liftoff ahead of schedule.
Inflation and supply-chain issues continue to be the focal points of global economic data as the market becomes desensitized to the narrative for “transitory” inflation. For example, headline inflation rates, as well as key subcomponents, remain above historical trend levels. As a result, eurodollar futures markets are currently front-loading interest rate liftoff expectations in the U.S. with about three total hikes by year-end 2022 and six total hikes by year-end 2023.
Across developed markets, a pronounced bear flattening trend is evident among five-year and 30-year government bonds. Relative to a lookback period of 15 years, sovereign yield curves in countries such as Canada, Germany and the U.K. are trending above their respective 70th percentiles of flatness—levels only observed in previous periods after monetary policy rates liftoff. Economic exposures to new virus variants, risk-asset corrections and geopolitical risks could drive global yield curves flatter over 2022.
A key technical factor that has aided flatter curve price action is the funding ratio of pension mandates, currently estimated at 98%, as measured by the Milliman 100 Pension Funding Index. Fully funded institutions have pressured long-end rates to the downside as the demand for long-duration assets has increased. In fact, the potential for a yield curve inversion cannot be ruled out as front-end rates react to the ensuing flurry of interest rate hikes, while long-end rates remain pressured by overfunded pensions.
In our view, yield curves will probably continue to flatten as inflationary concerns force central banks to aggressively adjust monetary policy and, in some cases, hike interest rates over the next two to three years. Further, the potential for policy mistakes appears to be increasing as central banks attempt to navigate unchartered levels of inflation, uncertain growth prospects and a range of supply chain issues. In our view, portfolio positioning should aim to capture dislocations in 2022.