There is no doubt about it, bond yields are under significant pressure. They have relentlessly marched higher, driven by both inflation and monetary policy concerns. There seems to be little end to the upward trend in sight, with policymakers waxing more hawkishly every time they speak. The 10yr UK government bond yield closed over 2% on 21st April , having started the day nearly 10 basis points below this level. So, what has changed? The inflation outlook has been known for some time, so why are yields continuing to price in ever higher premiums?
The key issue is inflation expectations. There has been concern for some time that persistently high inflation will feed into business price expectations and household wage expectations, changing a supply-driven price shock into a consumer driven wage-price spiral. As central bankers know, changing embedded expectations has historically been intensely difficult and required significant monetary policy action to effectively halt demand. This was apparent in the US in the early 1980s, in which a Federal Reserve led by Paul Volcker raised policy rates to 20% and incurred a recession in order to tame inflation. It is therefore no surprise that the developing theme among current central bankers is the preference for a shallow recession rather than tackling embedded high inflation expectations.
The Ukraine war has exacerbated the inflationary pressures already in the system and will, especially in the UK with its retail price cap regime for energy, prolong the period of high inflation into late 2022 and possibly beyond. The Chinese “Zero Covid” lockdowns further contribute by maintaining supply difficulties. Rises in oil, gas and commodity prices, delays in deliveries and supply bottlenecks, Brexit related frictions in the UK, mean that the inflation issue will not dissipate as quickly as initially thought. The risks of embedded high inflation expectations thus become more acute.
So, while international institutions have been downgrading growth forecasts amid a sharp deterioration in household confidence, central bankers have been out-doing themselves and each other in expressing the need for monetary tightening, particularly in the US, which has certainly found itself well behind the curve given the strength of the economy. Normally dovish US policymakers started discussing 50 basis point hikes, while the more hawkish have moved onto 75 basis point hikes and levels of 3.5% before year end (the US policy rate is currently between 0.25% and 0.50%). Yield curve inversions, a fairly good indicator of recession in the US, are explained away for various reasons, or simply accepted as a price to pay for taming inflation.
Investors, either anticipating ever higher levels for policy rates or just uncertain with what the future holds, have pushed market rates/yields to unthinkable levels just three months ago. The costs of households and businesses to borrow has already risen – the 30-year US mortgage rate is now over 5%, from just 3% around the turn of the year. Tighter financial conditions, arguably what policymakers are aiming for, are already occurring. Global bond yields are currently dancing to the Federal Reserve’s tune.
In the UK, the policy outlook is somewhat different, with the effects of energy rises more keenly felt by households and businesses. The Bank of England moved relatively early in December and raised rates for the third meeting in a row in March. It's fair to say that the March hike was delivered in a more dovish tone than expected and UK policymakers have sought to keep market interest rate expectations under control. However, the Bank’s forecasting record and ever higher inflation readings have prompted ever higher expectations for Bank Rate, the market believing that policymakers are wrong with the view that inflation is itself a self-correcting mechanism with high inflation ultimately taming high inflation in similar fashion to the inflationary spikes of 2008 or 2012.
The May Monetary Policy Report will make interesting reading. The inflation forecast will be notably above that of February, which in turn had been above November, but equally, the growth forecast will likely be notably lower as a result (unless the Bank makes some significant changes to its expectations for wage growth or use of the pandemic build up in savings). The February report indicated that inflation would have broadly rectified itself over the next few years, with the resulting deterioration in real household income dampening demand, even without further monetary tightening. But this was before the war, and now we can expect the inflation forecast to signal higher sustained levels of inflation. The February report also anticipated rising unemployment beyond the spring of 2022, and the fear of recession may push this trend in an upwards direction.
Will this change the view of UK policymakers? When they build the market’s path for Bank Rate into their forecasts in early May, will inflation fall below target as in February? Or will inflation remain above target throughout the forecast period, signalling even higher rates are necessary? Just a few weeks ago, we could have been relatively sure of the former – the market had seemingly gone too far and the Bank would communicate this in the fan charts. Inflation, being driven by global commodities, is acting as a drain on disposable income and reducing demand across the economy for other goods and services, bringing slower growth and higher unemployment, dampening wider pricing pressures and allowing the Bank to look through the energy spike without excessive further policy tightening. Wages are increasing, but at nowhere near the rate necessary to maintain high inflation, and pressure on business profitability will reduce wage growth.
But, as Catherine Mann (MPC Member) implied in a very recent speech, we continue to await signals that demand has started to ebb due to higher costs of living, and more importantly, this shift has been received by businesses, that will then start to pull back their price expectations. Data today indicated that consumer confidence has fallen to a 40-year low and this caution appears to be feeding into activity, so there are signs households are responding negatively to the fall in disposable income. However, and this is a key point, if firms do not act to curb their expectations for price increases, and there appears little sign of that so far, monetary policy will have to continue to tighten until the fall in demand leaves them with no choice. This appears to be the view of investors – pricing stubbornness will need to be squeezed out with the only (blunt) tool that the Bank has.
Where does that leave bond yields, specifically gilt yields? We noted in our last forecast that not only would yields increase in the near term, the risks around that path lay to the upside. However, we also perceived that when demand started to ebb and the need for policy tightening therefore reduced, investors would price out excessive tightening, placing some downward pressure on yields. From our point of view, the general shape of the forecast does not need to change, but the levels at each stage are clearly under consideration.
We find ourselves in an interesting paradigm; if inflation data continues to overshoot, policymakers will likely be more hawkish both in word and deed, even as inflation impairs economic performance, possibly to the point of recession. While the upside risks for our forecasts for bond yields over the near term are increasing, the same is true for the downside risks over the medium term, particularly in the UK where rates are rising into an already present cost of living squeeze (the situation could of course be further muddied if a desperate government were to choose to throw money at the problem).
Global bond yields are following the increasingly hawkish Federal Reserve, seeming to disregard domestic conditions. Uncertainty about how far the US central bank will go to tame inflation is causing bond market jitters, and this invariably leads to higher premiums to entice buyers. Until the Fed dials down the uncertainty, either by easing back on its rhetoric or, conversely, doing what it is saying it will do, upward pressure on yields will likely continue.