By Mike Dolan
LONDON (Reuters) – If skittish markets are just testing the extremes of possible central bank outcomes, policymakers who have bemoaned investor complacency for months may soon have to talk them off the cliff.
To be sure, financial markets typically behave like this – probing both sides of a most likely scenario and waiting for official pushback to better define the actual policy outcome.
And official indifference to sharp swings often emboldens that price search, even if some central bankers are inclined to dismiss all the action as noise – or even just ignore it.
For one, new Chicago Federal Reserve chief Austan Goolsbee said this week that it was “a danger and a mistake” to obsess too much about market reactions to the detriment of what’s happening on Main Street. “This is especially true when things are as strange and up in the air as they have been through much of the pandemic times,” he added.
And faced with markets pricing UK interest rates some 75 basis points above current levels, Bank of England Governor Andrew Bailey surprised many on Wednesday by saying more rate hikes were not “inevitably” needed.
But given the importance of interest rate and lending markets in transmitting monetary policy to the wider economy, both sides have at least an interest in regulating the amplitude of market mood swings – if that’s all that’s happening.
The biggest question in world finance right now is whether the eye-watering rebound in borrowing rates we’ve seen over the past month is just another overshoot – or the new reality.
Graphic 1: G7 2-year yields soar, https://fingfx.thomsonreuters.com/gfx/mkt/gkvlwlalypb/Three.PNG
Graphic 2: Fed, ECB and BoE ‘terminal rates’ rise, https://fingfx.thomsonreuters.com/gfx/mkt/movakqdqgva/Four.PNG
Graphic 3: https://fingfx.thomsonreuters.com/gfx/mkt/gkplwljemvb/One.PNG
LOSING THE PLOT
Since the middle of last year, futures markets have consistently priced peak Fed rates below where Fed officials themselves were guiding.
The assumption was the Fed would blink in the face of steady disinflation and possible recession and stop short – scenarios now in serious doubt after red-hot January soundings on jobs, retail sales and inflation around the world.
In the published quarterly projections of Fed policymakers from June, September and December, the so-called median ‘dot’ indicating likely interest rates this year was gradually moved higher from 3.8% to 4.6% and then to 5.1%.
But for at least six of the past nine months, futures markets priced a lower terminal rate than the central Fed view.
With a new ‘dot plot’ due later this month in the face of surprisingly strong new year employment, demand and inflation, markets have already moved the implied peak rate to 5.5% – above December’s Fed guidance but presumably taking account of another shift higher in official thinking this month.
Alarmingly, markets are now starting to price a 20% chance the Fed returns to a half-point hike this month – which would paint the decision to step down the pace of hikes last time out as a major policy mistake. The idea of a return to 50bp was egged on by Minneapolis Fed chief Neel Kashkari, a policy voter in 2023.
Wall St banks are scrambling to revise up forecasts. And where talk of 6% was deemed fanciful only a month ago, it’s now in the mix.
Unsure of where this dance ends amid constant revisions, bond markets have run scared. Two-year Treasury yields have now rocketed almost a full percentage point in one month to their highest in 15 years at just under 5% – suggesting few see any rate cuts over that horizon.
Ten-year yields have soared 75bps over February, retopping 4% for the first time in four months this week. Thirty-year fixed mortgage rates have jumped over half a point to 6.65%.
With European Central Bank ‘terminal rate’ forecasts also rising almost every week – sometimes by the same banks – amid an unnerving pickup in core inflation, euro bond yields are soaring likewise and German 10-year yields hit 11-year highs at 2.77%.
RULED OUT
But perhaps the most disturbing thing about this sudden tightening of financial conditions is inflation expectations are still rising anyway – suggesting the central banks may not in fact do enough to drag inflation back to 2% targets.
Two-year U.S. inflation expectations gleaned from the index-linked bond market have jumped to 3% for the first time since August and are up from 2% as recently as January.
Five-year equivalents have risen sharply too, while long-term euro zone inflation swaps are pricing the highest rates in more than a decade.
And all that angst in the face of one the most negative crude oil base effects in years – with benchmark oil prices now falling at a rate of 25-30% year on year and suggesting headline inflation rates may soon fall back below ‘core’ rates that exclude food and energy.
Have markets gone too far and need a nudge back?
A Cleveland Federal Reserve study of several “rule based” models of monetary policy suggests they may have – concluding the current stance of monetary policy is already more aggressive that any of these rules would have it.
TS Lombard strategists seem to agree – sticking with their forecast that a mild U.S. recession is due by mid-year and the Fed will indeed be cutting rates by yearend.
But in a report entitled ‘Bipolar Fed’, Andrea Cicione and Skylar Montgomery Koning reckoned the market call on yearend rates of 5-5.5% is “likely to be wrong” whatever happens. The outcome is “strongly bimodal”, they said, and either a recession hits and rates are cut, or it doesn’t and rates go to 6.5%.
Fed chief Jerome Powell’s congressional testimony next week has some heavy lifting to do.
Graphic 4: US inflation expectations and oil, https://fingfx.thomsonreuters.com/gfx/mkt/xmvjknenxpr/One.PNG
Graphic 5: US headline and core inflation, https://fingfx.thomsonreuters.com/gfx/mkt/myvmoaxarvr/Two.PNG
Graphic 6: https://fingfx.thomsonreuters.com/gfx/mkt/zdvxdxkxmvx/Five.PNG
The opinions expressed here are those of the author, a columnist for Reuters.
(By Mike Dolan, Twitter: @reutersMikeD; Editing by Andrea Ricci)
