Bond market signals concern Fed’s bid to cool inflation will backfire

Economy News


Bond markets are signaling increasing concern that the US central bank will derail the recovery from the pandemic by overreacting to severe inflation that is sweeping across the world’s biggest economy.

Short-term US government bonds have declined sharply this year, in a sell-off that gained momentum after the release of data last week showing consumer prices surged in January at the swiftest clip in four decades. The price fall has sent the yield on two-year Treasury notes, which are highly sensitive to monetary policy expectations, soaring to 1.6 per cent on Monday from 0.5 per cent three months ago.

Yields on debt maturing many years into the future – typically a barometer for investors’ assessment of economic growth prospects – have also risen, but to a lesser degree than those on the shorter end of the spectrum.

The result has been a dramatic “flattening” of the yield curve, as a narrowing gap between short- and long-dated yields is known. The move comes as traders now expect the Federal Reserve to deliver about seven quarter percentage point interest rate increases this year in its attempt to cool inflation. However, the flattening of the curve indicates that investors expect this policy could backfire by slowing the economy too aggressively.

“The US is now more definitely moving towards a late-cycle environment where Fed expectations are being repriced for ‘bad’ reasons,” said George Saravelos, Deutsche Bank’s global head of currency research. Supply constraints in the economy are fueling inflation, “requiring the central bank to slow down growth,” he added.

The difference between two and 10-year yields shrunk to 0.4 percentage points on Monday, its narrowest point on a closing basis since April 2020, having declined sharply in the wake of last week’s US inflation data. The difference in these two yields was about 1.2 percentage points a year ago.

Parts of the yield curve have even begun to flip upside down, typically an ominous signal for investors’ economic outlook. For example, seven-year yields on Monday ticked up above 10-year yields. This highlights the difficult balance the Fed has to strike between raising interest rates to tame inflation, but not moving so far that it hampers economic recovery. A more complete inversion of the curve – such as 10-year yields falling below short-term interest rates – has in the past been a reliable predictor of recession.

Line chart of the spread between two- and 10-year yields (percentage points) showing the US yield curve is flattening

“This is a very tough spot for the Fed,” said Edward Al-Hussainy, a rates strategist at Columbia Threadneedle. “[They] may have to live with an inverted curve for some time to squeeze out inflation risk. ”

Though a flattening yield curve is typically a sign of a slowing economy, there has been no evidence of that yet. The US earlier this month reported higher than forecast jobs growth in January and unexpectedly revised upwards employment figures for December and November. And the US economy grew last year at the fastest annual pace since 1984.

Some investors argue that while the Fed – and other central banks – made a mistake by being overly tolerant of inflation, they risk compounding that by tightening too fast as they play catch-up. Markets are now pricing in a high probability that the Fed lifts interest rates by an unusually large half a percentage point in March.

“We believe that a [0.5 percentage point] hike could do more harm than good as it could be seen by markets as a tacit admission of a policy error, requiring policymakers to jam the brakes on much more abruptly and raising recession risk in the quarters to come, ”said Mark Dowding, chief investment officer at BlueBay Asset Management.

The current dilemma is not unique to the Fed. In the UK, where the Bank of England has already raised interest rates twice, the flattening of the yield curve has been even more dramatic. Traders expect six more BoE rate rises this year, despite a weaker growth outlook than that in the US.

The gap between two and 10-year yields is just 0.09 percentage points, while the yield curve is inverted in several places. Three-year bond yields, at 1.48 per cent, are higher than 50-year bond yields.

Ultimately, some analysts argue, central bankers may need to choose between curbing inflation and keeping the recovery on track.

“If the Fed can fight inflation in the short term but that leads us into a recession, their credibility is maintained, and the US does not get into this stagflationary world,” said George Goncalves, head of US rates strategy at MUFG.

“Then real growth prospects in the distant future should be better. That’s the most optimistic I can get at this point. ”



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