Rates Spark: The New Normal
Summary
- Data is coming out in favour of those arguing inflation will remain persistent, and this means durably higher front-end volatility.
- It will take time for central banks to catch up to the market’s view.
- Depressed long-end rates will be more persistent, until markets accept that terminal rates have risen compared to previous cycles.
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By Antoine Bouvet, Benjamin Schroeder, Padhraic Garvey, CFA
Data is coming out in favour of those arguing inflation will remain persistent, and this means durably higher front-end volatility. It will take time for central banks to catch up to the market’s view. Depressed long-end rates will be more persistent, until markets accept that terminal rates have risen compared to previous cycles
Persistent inflation, and volatility
Markets have to get used to a world where the range of possible economic outcomes is much wider than over the past decade, ranging from persistent inflation to a central bank-induced recession. That markets oscillate between these two extreme outcomes is not surprising, and time only will tell which is closer to reality. A stagflation outcome where both risks materialise seems a lot less credible to us.
Higher volatility and wider spreads are signs of lower central bank support
So far, we think the inflationary narrative has the upper hand. Given the recent string of inflationary economic releases and news headlines, it is only natural for markets to be concerned that central banks are, generally speaking, behind the curve. This explains the rise in volatility at the policy-sensitive front-end, also why market tightening expectations have run ahead of central bank signaling. Barring a dramatic hawkish turn at this week’s Fed and BoE meetings, we think this state of play will persist, and so will front-end rates volatility. The continued widening of peripheral spreads since the October ECB meeting is a sign that this view is gaining in popularity.
Long-end flattening: focus on the terminal rate
What then of the long-end flattening that seems to embody market concerns about an impending economic slowdown, if not recession in some cases? Firstly, we think of long-end rates as less reliable indicators of central bank policy expectations. This is because a broader range of factors seems to affect them, and because any central bank view would take a lot longer to be proven right or wrong at the long-end. This being said, low long-end rates can only exist in case of a supply-demand imbalance. With Fed and ECB purchases continuing at (almost) full speed for the rest of the year, we are tempted to ascribe low interest rates at least partially to residual central bank interventions.
Only the acceptance of a higher terminal rate would allow curves to re-steepen
If we’re right, then this state of play should change when tapering gets under way, and so will the fate of long-dated bonds. We are unsure Monday’s long-end sell-off is the start of a bigger trend given the proximity of central bank meetings, and so the increased focus on front-end rates. At a minimum, central bankers have to prove to investors that they are taking inflation risk more seriously this week. This is a necessary condition for markets to get over the ‘behind the curve’ narrative, but not a sufficient one to dispel the widespread gloom that prevents the long-end from rising.
Today's acknowledgement by the RBA that hikes are coming earlier than the previously signaled timeline, and the abandonment of the 0.1% yield curve control target, are signs that a hawkish move can contribute to a re-steepening of yield curves. The question is whether the BoE and Fed can afford such a change of communication. In the case of the BoE, a hike would be a step in this direction. In the case of the Fed, we doubt it will want to compound the risk of tapering with a more hawkish signal on rates.
The more important factor is whether markets accept that the terminal rate has risen compared to the previous cycle. If they do, then long-end rates have scope to move higher. A string of positive economic numbers will help achieve that, but we think this process will take time.
Today's events and market view
Of the batch of European PMIs released today, only Spain's and Italy's are first readings. Their global relevance is, of course, limited, but peripheral spreads have been a particular flashpoint since the October ECB meeting. Any weakness in today's data would compound their woes.
Today's supply slate is comprised of 15Y Austria and German inflation-linked bonds.
After the aforementioned rise in EUR rate and spread volatility since last week's ECB meeting, hopes are for soothing words coming from officials on the docket today: Andrea Enria, Frank Elderson, and Luis de Cos.
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