Bond traders largely had accepted central banks’ assurances that high inflation is “temporary” or “transitory” and bought and sold bonds at prices and yields reflecting that view.
However, with this autumn’s spike in energy prices, combined with unrelieved supply-line clogs, bond markets are setting yields higher in the expectation the U.S. Federal Reserve will be forced to raise rates sooner than the late 2022 date that the Fed has signaled, The Wall Street Journal reported.
Some investors are expecting the Fed to raise rates several times next year, a notion that kept yields on two-year bonds at 0.5 percent, the highest return since March 2020.
“Bond investors are concerned that the Fed is not addressing the inflation risks,” Lawrence Milstein, head of treasuries trading at R.W. Pressprich & Co. told the WSJ.
Other central banks already are shifting policy in ways that reflect the bond market’s bet.
Last week, the Bank of Canada abruptly announced it is ending its purchases of government bonds, while holding its 0.25 benchmark interest rate steady.
Also last week, the Reserve Bank of Australia allowed a three-year bond yield to surge to 0.85 percent, far above the bank’s 0.1-percent target.
Eurozone bond investors are bidding up yields, too, apparently disbelieving European Central Bank (ECB) president Christine Lagarde’s insistence that the bank will not raise interest rates for years to come (“Will ECB Hold to Negative Interest Rate?” 2 Nov 2021).
Based on bond pricing, the U.S. market is making a 50-50 bet that U.S. interest rates will rise by the middle of next year, the WSJ noted, months sooner than the Fed has formally stated.
Fed funds futures, a gauge of the market’s hunches about monetary policy, last week registered a 35-percent chance that the U.S. central bank would raise rates at least three times next year, 5 percentage points more than a month earlier.
At the same time, yields are moderating on longer-term bonds, indicating that investors believe inflation and supply chain snarls will slow growth.
“Rates in the Eurozone and the U.S. have, on multiple occasions, been driven by the anticipated actions of central banks that are normally on the periphery,” Rabobank rates strategist Richard McGuire pointed out in a WSJ comment.
“Market participants are looking to these more peripheral central banks as providing a lead indicator of what the Fed and ECB will have to do next,” he said.
“Investors are testing central banks’ resolve that all this is temporary and forcing their hand,” Andrea Iannielli, Fidelity International’s investment director, said to the WSJ.
“A big shift is afoot in monetary policy,” she said.
The shift is akin to the end of the Bretton Woods monetary system in the 1970s, George Saravellos, Deutsche Bank’s chief currency researcher, said in a WSJ interview, citing the 1944 agreement by major nations on rules to govern their financial interactions.
In a series of “attacks…one after the other, central bank communication is being challenged and unraveled by the market,” he said.
However, treasury secretary Janet Yellin failed to get the bond market’s memo.
Inflation remains transitory and the U.S. economy is not overheating, she insisted in a public statement last week, despite business leaders’ warnings that persistent shortages of a range of workers and materials continue to drive prices higher.
Inflation is “higher than we have seen in a number of years,” she acknowledged, but said that is due to the presence of the COVID virus.
The U.S. Consumer Price Index rose at a 4.4-percent pace in September, its fastest since 1991.
As the virus is curtailed, “these pressures will ease and, in that sense, I believe the inflation is transitory and we don’t have an economy that is overheating” over the long term,” she said.
TREND FORECAST: The economy may not overheat in the long term, as Yellin predicted, but it is overheating in some segments now and shows every indication that minus interest rate spikes, the fire will burn hot through next spring at least.
Inflation will continue to rage as supply chains remain tangled for months (see related story in this issue) and shortages of key minerals will persist even longer than supply lines are kinked.
The Fed will face growing pressure to raise rates to avoid a runaway wage-price spiral (“Fed’s Key Inflation Gauge Hits 30-Year High,” 5 Oct 2021). If it speeds its exit from bond markets or hikes rates on short notice, stock and bond markets will plummet.