Orlando, Fla. (Businesshala) – The US and UK bond markets are ringing economic alarm bells.
The yield curve is flattening dramatically in both markets, indicating that traders are pricing in an increased risk of central bank policy error or an increasingly bleak outlook for long-term growth.
The eye-catching move is being driven by the long end of the curve, where 30-year yields are falling sharply. At the same time, traders are forecasting the first inflation-fighting interest rate hikes from the Federal Reserve and the Bank of England.
Even though policy rates are at zero lows and are unlikely to rise much after liftoff, a premature tightening to fight supply shock-fueled inflation could still stifle growth and propel the economy into recession. Is.
The European Central Bank’s infamous 2011 rate hike, which deepened the region’s debt crisis and triggered a recession, are mistakes no central banker wants to repeat.
Yields decrease when the difference between short- and long-term borrowing costs decreases, and they reverse when long-term yields fall below short-day yields. Both scenarios, especially inversions, are often preceded by slow growth and sometimes a recession.
In this context, Wednesday’s steps are being closely watched.
In the United States, the 10s/30s curve has flattened below 50 basis points for the first time since the outbreak of the COVID-19 pandemic in March 2020.
The 2s/30s curve flattened 9 basis points for the second day in a row. The cumulative 18 basis point drop is the biggest fall in two days in a decade.
The UK 2s/30s spread, meanwhile, narrowed by 15 basis points on Wednesday, the most in a single day since March 2020 and one of the biggest declines in a decade.
The 10/30s curve narrowed to just 23 basis points, the flattest since the dark and volatile days of late 2008.
This comes against the backdrop of the highest inflation in years and the timing of the first rate hike in financial markets. Rate markets now expect the BoE to move this December and the Fed in September 2022.
A drop in yield shows that the bond market thinks it is risky.
A Deutsche Bank poll of more than 600 market professionals this month showed that central bank policy error is now the second biggest risk to market stability, behind high bond yields and inflation, and ahead of growth concerns.
Interestingly, while keeping policy very loose, the Fed’s error would be a folly. Ultimately, however, the economic damage may resemble a blatant mistake, as high inflation will reduce consumer income and corporate profits, regardless of growth.
But tightening too quickly or too much is probably the bigger gamble, which is why the Fed may be inclined to allow inflation to warm up a bit now to mitigate the more volatile risk of deflation when the next recession hits.
“The Fed could do some real damage by moving too quickly,” warned Scott Kimball, co-head of US fixed income at BMO Global Asset Management.
Minutes of the Fed’s September policy meeting published on Wednesday showed that “various” participants believe economic conditions justify keeping the fed funds rate “at or near its lower limit over the next few years.” prove it. Many of them said there is likely to be “continued downward pressure on inflation in the coming years”.
On the other hand, “a number” of participants argue that labor market and inflationary conditions will allow the Fed to raise rates by the end of next year. Some of them expect inflation to pick up in 2022, with risks that may increase.
What is the larger group of FOMC members, “various” or “number”?
In the UK, as the Deutsche Bank survey shows, the risk appears to be much more pronounced: the BoE will raise rates too quickly.
Futures markets are now pricing in almost a 15-basis-point rate hike in December, a full quarter-point increase by February, and 50 basis points by May.
Bank officials have done little to push back these aggressive market expectations. His silence has only fueled the frenzy, and retreating now will damage his credibility.
It should be argued that pre-emptive rate hikes are needed to stabilize inflation expectations, thereby limiting the final number and scale of growth.
But as Ross Walker at NatWest Markets wrote during the weekend, “stopping domestic demand to arithmetically offset external cost pressures is a disappointing prospect.”
“If there is a monetary policy error – premature and excessive rate hikes – it will happen in the UK.”