Why is the market testing central banks' policy prescription?
Since November more investors have begun to speculate that interest rates will need to lift earlier than current central bank guidance.
The resurgence of the virus during the Northern hemisphere winter brought a partial reversal in the improvement of economic data. However, the development of vaccines has strengthened investors conviction in the eventual economic rebound. This view is also buttressed by government support via spending and central bank via low interest rates and bond buying. At the same time, there has been increased investor concern about the size of the expansion of monetary supply, the implications for inflation and the role this may be playing in stoking the high valuations of many equities and speculative investor behaviour.
Inflation pricing outlook
Inflation expectations in the US for the next 5 years (white line) have risen steadily since the peak of the crisis in March 2020, however expectations for the 5 years starting in 5 years (blue line) not so much. In fact, longer term expectations have now crossed over shorter term expectations, signalling that after a period the market expects inflation will recede.
Government bond auction
Recently, the pressure for higher yields catalysed on 25 February, as an auction for US 7 year government debt met much lower demand than expected. In the aftermath, US 2 year government yields rose 5bps, 7 year yields rose 20bps and 10 year yields rose 16bps. Yields in other markets also rose. In Australia, 10 year government yields rose 35bps. These rises also caused equities and many commodities to fall, and saw a rise in the US$.
Another taper tantrum?
Unlike the taper tantrum of 2013, the rise in yields on 25 February runs counter to current central bank statements and guidance. Notably, there was no particular release of economic data that surprised the market (like 1994).
What next for bond markets
We expect central banks will defend their commitments for low rates. Given that they have almost unlimited ability to manage bond yields (in their own currency) it seems likely that yields will stabilise for now. Assuming that markets continue to function effectively, we don't expect any immediate definitive change in policy from central banks.
The purpose of the RBA’s yield curve control policy is not to prop up bond investors or the stock market but both are clearly beneficiaries of well executed policy clarity. Some analysts have suggested that, as economies have begun to recover, market forces should now be allowed to dictate all prices in the government bond market. We don’t think markets are at that point yet. Taking this step would be a reversal of policy clarity and almost certainly result in a severe tightening in financial conditions.
We think that certain emergency monetary policy measures may soon be able to runoff. However we expect that government budget deficits will be reduced before interest rates are raised materially. Longer term Longer term, there are various factors which we believe will sustain low inflation, such as technology driven gains in productivity, ongoing lower demand for labour and bargaining power, excess capacity from global supply chains and large balances of debt outstanding. However factors such as the current monetary and fiscal policy experimentation, diminishing conviction in democracies and capitalism and supply interruptions may generate levels of undesirable inflation. Finally, current valuations of major asset classes are expensive based on many historical measures. We believe this suggests that real returns over the next 10 years will be lower than experienced in recent decades.
Source: Darling Macro, Bloomberg. For wholesale investors only.