LONDON, March 3 (Reuters) – With nervous markets only testing the extremes of possible central bank outcomes, policymakers who have bemoaned investor complacency for months may soon have to lure them off the cliff.
Of course, that’s how financial markets usually behave – examining both sides of a most likely scenario and waiting for official resistance to better define the actual policy outcome.
And official indifference to sharp swings often encourages this price hunt, though some central bankers tend to dismiss the whole action as noise — or even outright ignore it.
For one, the new Chicago Federal Reserve chief, Austan Goolsbee, said this week it was “a hazard and a mistake” to focus too much on market reactions to the detriment of what’s happening on Main Street. “This is especially true when things are as strange and up in the air as they have been in many pandemic times,” he added.
And with markets fixing UK interest rates some 75 basis points above current levels, Bank of England Governor Andrew Bailey surprised many on Wednesday by saying further rate hikes were not “inevitable”.
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But given the importance of interest rate and credit markets in transmitting monetary policy to the broader economy, both sides have at least an interest in regulating the amplitude of swings in market sentiment – if that’s all that happens.
The biggest question in world finance right now is whether the stunning rebound in lending rates we’ve seen over the past month is just another overshoot – or the new reality.
G7 2-year yields riseFed, ECB and BoE ‘tail rates’ riseGlobal economy surprises in 2023
LOSING THE FOUNDATION
Since the middle of last year, futures markets have consistently priced in peak Fed interest rates below the Fed officials themselves.
The assumption was that the Fed would blink and pause in the face of steady disinflation and a possible recession — scenarios that are now being seriously questioned after January’s red-hot soundings on jobs, retail sales and inflation around the world.
In the Fed policymakers’ published quarterly projections for June, September and December, the so-called median ‘point’, which indicates likely interest rates this year, gradually increased from 3.8% to 4.6% and then to 5. 1% increased.
But for at least six of the past nine months, futures markets have priced in a lower terminal rate than the central Fed’s view.
With a new dot plot due later this month amid surprisingly strong employment, demand and inflation going into the new year, markets have already raised the implied prime interest rate to 5.5% – above the Fed’s December forecast, but likely considering another upward shift in official thinking this month.
Alarmingly, markets are now starting to price in a 20% chance that the Fed will return to a half-point hike this month – which would make the decision to slow the pace of rate hikes last time out a major policy mistake. The idea of a return to 50 basis points was egged on by Minneapolis Fed Chair Neel Kashkari, a 2023 political voter.
Wall Street banks are scrambling to upgrade their forecasts. And where the 6% talk was considered imaginative a month ago, it’s now in the mix.
Uncertain of where this dance will end amid constant revisions, bond markets have become scared. Two-year government bond yields are now up almost a full percentage point in a month to a 15-year high of just under 5% – suggesting few expect rate cuts over that horizon.
10-year yields rose 75 basis points in February and returned to 4% this week for the first time in four months. 30-year fixed-rate mortgage rates are up over half a point to 6.65%.
With the European Central Bank’s “final interest rate” forecasts also rising almost every week – sometimes by the same banks – amid a worrying rise in core inflation, euro bond yields are also soaring, with German 10-year bond yields also peaking 2.77% an 11-year high.
EXCLUDED
But perhaps most worrying about this sudden tightening in financial conditions is that inflation expectations are still rising anyway – suggesting central banks may not be doing enough to push inflation back towards the 2% target.
US two-year inflation expectations, as measured by the index-linked bond market, rose to 3% for the first time since August, from 2% in January.
Five-year equivalents are also up sharply, while long-dated Eurozone inflation swaps are pricing in the highest interest rates in more than a decade.
And all that fear in the face of one of the most negative crude oil base effects in years – with benchmark oil prices now falling 25-30% annually, suggesting headline inflation rates could soon fall back below “core” rates in the food and energy sectors exclude.
Have the markets gone too far and need a nudge back?
A study by the Cleveland Federal Reserve of several “rules-based” models of monetary policy suggests that this may be the case – concluding that the current stance on monetary policy is already more aggressive than any of those rules.
TS Lombard strategists seem to agree and are sticking to their forecast that a mild US recession is imminent by mid-year and that the Fed will indeed cut rates by the end of the year.
But in a report titled Bipolar Fed, Andrea Cicione and Skylar Montgomery Koning opined that the market call for year-end rates of 5-5.5% is “probably wrong” whatever happens. The result is “strongly bimodal,” they said, and either a recession hits and rates go down or it doesn’t and rates go to 6.5%.
Fed Chair Jerome Powell’s testimony before Congress next week is busy.
US inflation expectations and oil
The opinions expressed here are those of the author, a columnist for Reuters.
By Mike Dolan, Twitter: @reutersMikeD; Editing by Andrea Ricci
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