Interest rates are increasing. They have been trending up since mid-2020. This coincided with the inflation pressures following the COVID supply chain problems. It then accelerated gradually as economies and labour markets recovered. How long will this trend continue? Will Bond markets find a new equilibrium in the near future?
Initially, central banks downplayed the pressure from inflation as a temporary problem. Everyone agreed to this. In fact, we still believe that inflation will come down from its current heights. The problem is that the inflation dynamic in the post-covid recovery has become very complex. Large economic volatility combined with unprecedented monetary and fiscal stimuli made accurate short-term forecasting difficult. The initial plan of central banks was to let inflation normalise on the back of the gradual resolution of supply and demand mismatches, rather than doing aggressive tightening and putting the economic recovery and job market at risk. The consequences of the war in Ukraine complicate matters further. There is more inflation pressure. The risk of larger second round effects and higher inflation expectations have become real.
In the US, Jerome Powell, after his renomination as Fed Chairman on November 22, 2021, changed tack. Given the tight labour market, the Fed made managing inflation the only important priority. The ECB and other central banks followed a similar narrative.
In the past, markets have been quick to price in Fed hikes. But every time they have been surprised by a Fed that has ultimately been more dovish. This was certainly the case with Yellen. The market has become preconditioned that the Fed will be more dovish than expected.
This time, Powell has almost become more hawkish than the market, given the higher inflation background. The market is catching up. We are in a high inflation framework with central banks struggling to control the inflation narrative. We haven’t been in such a situation for 40 years. And back then, the economic and central bank setup was very different. Hence, the market has no pricing reference framework. The bond market is in price discovery mode.
Consequently, interest rates are increasing, and many yield curves are flattening:
