Capital markets are increasingly pricing in inflation risk
Volatility in the bond markets has increased most noticeably in the short-dated government bond segment. This is because higher inflation risk is being priced in and some second-tier central banks have started to tighten their monetary policy. However, Union Investment expects inflation rates to come down again in 2022.
The bond markets have become more jittery. Yield curves have started to move, especially at the short-dated end. Some regions have recently seen a substantial upward swing. This has prompted a marked flattening of yield curves in the markets for Canadian, UK, US and other government bonds. The yield spread between ten-year and 30-year Bunds has also been narrowing recently, reaching 28 basis points at the end of October. In part, this was likely driven by large investors, such as hedge funds, that adjusted their positions and thereby caused heightened volatility.
Some investors regard the combination of a yield curve that is flattening from the short end and an environment of weakening economic growth – as can be seen in certain countries – as a bad omen for risk assets such as equities. Against this backdrop, talk of a potential ‘policy error’, i.e. a mistake in the monetary policy of the central banks, has started to emerge because the expectations that the markets have priced in with regard to interest-rate changes by the US Federal Reserve and the European Central Bank differ quite substantially from the forward guidance issued by the central banks themselves. Other factions believe that the central banks are underestimating the prevailing inflation risk and holding on to their expansionary approach for too long.
The central banks are faced with a dilemma, and the ECB even more so than others. If the ECB acts in line with the markets’ accelerated expectations and starts to raise interest rates in 2022, it runs the risk of stifling the economic upturn and missing its inflation target yet again when current one-off effects wear off. But if inflation proves more persistent than expected and the bank waits too long before it responds, it risks having to take much more drastic action later on.
Marked increase in inflation in Europe
At present, inflation seems to be rising more sharply than anticipated by the central banks, due to a jump in energy prices and supply chain bottlenecks. For example, inflation in Germany rose to 4.6 per cent in October while the rate in Spain was even higher at 5.5 per cent. This environment is reflected in the inflation expectations that are being priced in by the markets. Five-year US inflation expectations, measured by inflation swaps, have climbed to a seven-year high. The equivalent figure for the eurozone has also risen to its highest level since August 2014.
The Federal Reserve emphasised that it expected inflation rates to decline again next year, and both the ECB and the Bank of Japan recently echoed this view. There is widespread agreement that inflation will come down in 2022, but that upward pressure on prices will grow in the medium term. However, market participants disagree about what level inflation will drop to when the currently prevailing one-off effects subside and about the extent to which inflationary pressure will increase over the medium term. Those who believe that inflation is not just flaring up temporarily but could remain high for a prolonged period saw their views confirmed by news from Canada, Brazil and Australia. Canada’s central bank ended its asset purchase programme on 27 October. It also now expects the output gap to close sooner, namely before the middle of 2022. This suggests that interest rates might go up more swiftly. The central bank of Brazil raised its base rate by 150 basis points to 7.75 per cent on 27 October due to high levels of inflation in the country and announced further interest-rate hikes.
ECB remains calm and rejects market expectations
According to statements made by ECB President Christine Lagarde at the press conference on 28 October following the bank’s interest-rate meeting, the ECB is still a long way away from its first interest-rate increase. The ECB is monitoring developments in the eurozone and emphasised that even if the upward trend in prices persisted for longer than anticipated, inflation should come down again significantly next year from the present high levels. The market seems to disagree and continues to price in a first interest-rate hike for the end of 2022. It will probably take at least until December before market expectations start to shift backwards. At this point, the ECB will likely publish an inflation forecast of under 2 per cent for 2024. Moreover, Union Investment expects the ECB to continue to purchase bonds through its regular asset purchase programme (APP) until long after the end of its pandemic emergency purchase programme (PEPP).
The US yield curve has flattened too (see chart). For the first time ever, the yield spread between 20-year and 30-year US Treasuries has dropped into negative territory. We expect the Fed to announce the commencement of tapering measures (i.e. the reduction of bond purchases) at the next Federal Open Market Committee (FOMC) meeting in early November, with a view to phasing purchases out completely by mid-2022. Interest rates could then start to go up in early 2023. The expectations currently being priced into interest-rate derivatives by the markets suggest that the first interest-rate hike might yet happen in 2022.
Marked rise in yields at the short-dated end
Yields are going up again
No hasty tightening of monetary policy
We believe that the market is currently painting a largely exaggerated picture of inflation risk. Already, there are signs that disruptions to supply chains and upward pressure on energy prices are easing. As long as wages and prices do not begin to spiral upward on a broad scale, inflation should settle down in 2022, before shifting to a moderate upward trajectory in line with the ECB’s targets over the coming years. This should allow the Fed and the ECB to continue to gradually tighten their monetary policy and will keep the markets for risk assets well supported.
As at: 01 November 2021.