Beware complacent central banks and bond markets
This article does not constitute advice or any form of investment recommendation. All numbers quoted were sourced from Bloomberg data as at Tuesday 28 February 2023. Past performance is never a guarantee of future performance.
- In deciding how much further to hike rates, there is a real risk of central bankers being complacent and potentially adding to market volatility by making the wrong policy decisions.
- The question as to when US interest rates will hit a peak, and what that peak might be, will grip financial markets this year. Given that the labour market remains ‘hot’, it seems likely that the top of the Fed funds rate in this hiking cycle could be 5.5%, at a minimum.
- The dangers of poor policy decisions are amplified by rate-setters being in the odd position of trying to cool inflation when the economy is still growing, rather than contracting, and the labour market is tight.
- US rate-hiking cycles since 1972 show that the peak policy rate tended to last for only six months. However, 24 months after hitting the peak, the average policy rate was around 60% of that level on average.
- Rather than trying to time the peak in rates precisely, given the risk that the Fed might cut rates quickly, locking in yields during the current phase of re-pricing in the bond market might appeal to some investors.
The signs are that this year could be another particularly volatile one for bond markets and central bank policymakers. In the search for the peak in interest rates and the right medicine to tame inflation, the scope for policymakers and markets to make the wrong calls is high. Being complacent, which policymakers and rate markets have been guilty of in the past, could add to the volatility in the market. So, what might this mean for bond investors?
Learning from your mistakes
The US Federal Reserve (Fed) was, in hindsight, too complacent about potential inflation risks in 2021 when it regarded a surge in prices to be transitory. Since then, the central bank has seen the light, kicking off the quickest pace of rate hikes since the 1980s.
The bond market has arguably been in complacent mood between September 2022 and early February 2023 (and the release of data that still pointed to a tight US labour market). In that time, 2-year yields dropped by one percentage point in the UK and the US, reflecting potential overconfidence in the inflation rate being brought down speedily.
During that time, the rate market thought the peak in the US policy rate would be lower than had been expected, and that rate cuts would be seen early this year; just as the central bank was warning against such euphoria. Given that the labour market remains ‘hot’, it seems likely that the top of the Fed funds rate in this hiking cycle will be 5.5%, at a minimum.
The recent period of fast-falling rates and tighter credit spreads – a closely watched barometer of wider economic health, measuring differences in yield between government bonds and corporate bonds of the same maturity - may gradually come to end. The disinflationary effects from goods price growth will run out of steam, while the stickier “core” inflation components, which exclude the typically more volatile food and energy components, still feel the full force of higher rates. The question is when.
Such an event, or end to the “disinflation party”, will take some time. However, until surprisingly strong US job data in February, the bond market had largely turned a blind eye towards to this possibility.
What next for peak-rate expectations?
The question over what rate, and when US interest rates will hit a peak, will grip financial markets this year. The futures market is pricing in a peak rate of around 5.25%, though it may need to be hiked to 5.5% or even higher, depending on the outlook for inflation. As the market wakes up to reality, heightened volatility seems all but assured.
While interest rates are set to climb, as policymakers try to bring inflation back to a common 2% policy target, the US central bank could eventually act swiftly to cut rates. As such, the question of when to lock in rates remains valid.
Different playbook clouds policy decisions
Policymakers are trying to make the right calls on interest-rate policy in strange, unusual circumstances. The Fed wants to tame inflation during both a ‘hot’, or tight, domestic labour market - which is typically a dangerous inflation signal - and a still growing economy.
History shows that inflation has usually cooled after a substantial slowdown, if not only after a recession. This suggests two potential scenarios:
- a slowdown, cooling inflation and perhaps rate cuts towards next year; or,
- a more resilient economy than expected, with inflation staying high for longer than anticipated.
If the latter scenario occurs, the Fed may need to hike rates by more than currently envisioned, in order to force a slowdown.
Whichever scenario plays out, it seems more likely than not that the central bank will err towards cutting, not hiking, rates this year and next.
Time to lock in rates?
For now, a somewhat higher, and potentially longer, peak might be on the cards. Rate cuts are on the way at some point and could happen swiftly. In the meantime, the opportunity to lock in yields now, rather than trying to time a future peak (and risk getting it wrong), might appeal to some investors.