Central banks normally dictate to the bond market. But now, investors are ramping up bets that policymakers have got inflation all wrong, and are forcing some to change tack.
For much of this year, investors had swallowed central bankers’ mantra that there was no need to raise interest rates to combat a “transitory” burst of inflation. But an autumn surge in energy prices, and the surprising persistence of supply bottlenecks in the global economy, have sparked an increase in bets on earlier increases in borrowing costs.
Some central bankers have appeared to follow where markets have led. The Reserve Bank of Australia last week allowed a key three-year bond yield to surge to 0.85 per cent, well above its 0.1 per cent target — apparently surrendering to heavy downward pressure on the debt’s price.
The Bank of Canada’s abrupt decision to scrap its own quantitative easing programme last week poured fuel on a bond price decline that was already under way. And investors have taken the fight to the European Central Bank, dialling up their rate rise bets for next year despite president Christine Lagarde’s insistence that such a move was inconsistent with the central bank’s guidance.
“Investors are testing central banks’ resolve that all this is temporary and forcing their hands,” said Andrea Iannelli, investment director at Fidelity International. “A big shift is afoot in monetary policy.”
The Bank of England, by contrast, has cheered the market along, triggering a big retreat in short-term UK government debt prices — which soon spread to other bond markets — when it signalled in September that a 2021 rate rise was a possibility.
“One after another, central bank communication is being challenged and successfully unravelled by the market,” said George Saravelos, Deutsche Bank’s global head of currency research. Saravelos likened the recent wave of “attacks” on central bank guidance to the end of the Bretton Woods monetary system in the early 1970s.
Short-dated bond borrowing costs have surged everywhere. US two-year yields hit 0.55 per cent on Friday, their highest since before the pandemic and up from 0.21 per cent a month ago. Moves have been even sharper in the UK, Australia and Canada, and have also shifted notably higher across the euro area.
The market shakeout has raised the stakes ahead of the Federal Reserve’s meeting on Wednesday, at which the world’s most influential central bank is widely expected to announce the start of a reduction in its pandemic-era bond purchases. But the Fed will also be under pressure to respond to market pricing, which points to a 50 per cent chance of a rate rise by the middle of next year, earlier than most policymakers have signalled.
“The Fed credibility gap is large and growing and needs to be addressed [by chair Jay Powell] this week,” Saravelos said.
In a pivotal week for central bank meetings, the RBA will be under pressure to reveal on Tuesday if it indeed intends formally to ditch a key part of its bond-buying programme after yields flew past its target, and on Thursday the BoE is expected by investors to lift rates from record lows.
Global investors are likely to be paying unusually close attention to these typically less influential central banks, which have sent shockwaves through the world’s larger bond markets in recent weeks.
“Rates in the eurozone and US have on multiple occasions been driven by the anticipated actions of central banks that are normally on the periphery,” said Rabobank rates strategist Richard McGuire. “Essentially, market participants are looking to these more peripheral central banks as providing a lead indicator of what the Fed and ECB will be having to do next.”
Some investors say markets have gone too far in betting that bigger economies will follow this lead. Iannelli said he was considering buying German bonds, which should benefit from more convincing pushback from the ECB against 2022 rate-rise expectations.
Others are reluctant to step in while markets remain so volatile. James Athey, a bond portfolio manager at Aberdeen Standard Investments said the path of interest rates implied by markets for economies like the UK and Australia was unlikely to be borne out with actual rate increases.
But markets were likely to remain choppy while investors were forced to abandon earlier bets on rates staying low, he said.
“A lot of people had swallowed the central bank guidance that this inflation was all transitory, and now they’ve been burnt,” he said. “You’re just seeing this bloodletting as people get stopped out of their positions, and it could go on a while longer.”