Central banks and markets are facing off over bond yields, but policymakers are clearly signalling a peak in interest rates.
It’s like early 2022 all over again. Bond and equity prices have again been correcting sharply lower over recent weeks.
But we’re not amid a post-pandemic rebound in economic growth, super-charged by too-low interest rates and generous government handouts. Nor is inflation being squeezed higher by the supply chain gridlock that dominated 2021 and 2022.
Equity indexes have fallen since their highs at the end of July, and the Australian and US markets are down about 7 per cent at the close of the first week of October. But while equity markets haven’t really exited their relatively tight trading ranges for the past year or so, long-dated 10-year government bond yields have risen to highs not seen since before the GFC, more than 16 years ago.
The primary catalyst for the bond rout appears to be concern by investors that central banks are “pulling up stumps” too early in their inflation fight. Growth is too strong, and inflation is not yet back within most central banks’ target ranges.
The job is simply not done.
Central banks, however, have headed off in a different direction. While not quite calling it done, they are clearly signalling a peak in policy rates with a view to holding policy restrictive for an extended period as a way to bring inflation back to target over time.
Indeed, for the US Federal Reserve, inflation isn’t forecast to be at target until 2026, and in Australia’s case late 2025. This is arguably a slower pace (two to three years) than the typical allowance (often one to two years) embedded in many central banks’ inflation-targeting frameworks.
Yet, this is straight from the “opportunistic disinflation” playbook outlined almost three decades ago by two central bankers at the US Fed. In 1996, Athanasios Orphanides and David Wilcox argued that “when inflation is moderate but still above the long-run objective, [central banks] should not take deliberate anti-inflation action, but rather should wait for external circumstances – such as favourable supply shocks and unforeseen recessions – to deliver the desired reduction in inflation”.
The essence of the thesis is that after having increased rates significantly to get inflation down from ultra-high levels to close to, but not yet within, target, the “sacrifice of output” (or likely higher unemployment) needed to force inflation down to the target is seen to be “too great” to accept.
Of course, given the chequered more recent policy experience of central banks – arguably holding policy too low for too long and having to lift rates rapidly – policymakers may also be quietly questioning whether they have the political capital to pay the price of higher unemployment, if indeed that is required near-term to deliver “at-target” inflation.
While bond vigilantes appear to be pushing central banks to pay that price, the message being delivered from a (very) wide range of central banks is that policy is already restrictive, inflation is on a moderating trend (even if not yet in target), and growth is at or moving below trend.
For now, the economic data is landing more on the side of the central banks, and the market-induced increase in yields can only help. US growth is without doubt proving resilient. But growth is close to zero in Europe and Britain, and below trend in Australia and China.
Recent monthly data also reveal “close to target” inflation, with Australia annualising at 3.6 per cent and the US at 2.5 per cent. Sure, jobs markets globally remain tight, but even here there are signs of less wage pressure as the trend in jobs growth and vacancies drifts lower.
The outlook is not without risk. Even adopting an “opportunistic disinflation” path – as central banks appear to be doing – requires action if inflation reaccelerates. But this seems less likely because keeping policy rates high as inflation falls will further tighten the “real” pressure on economies. Nor has the past policy tightening had enough time to fully weigh on consumers.
Over coming months, slowing growth and easing inflation pressures should work to keep the bond vigilantes at bay and drive some reversal in the recent bond yield spike.
Of course, the other most likely reason yields have been rising is the seemingly untethered debt position and political chaos in the US. If markets decide this must be fixed imminently, the odds of a recession rise as sharply higher yields will work to cause something to break.
Yet, even here, the risk-reward of an allocation to government bonds still appears compelling at this stage of the cycle, an increasingly consensus view among asset allocators over the past year. Consensus is typically an unpopular place to be. But it doesn’t always make it wrong.
