Analysis: The bond markets assume that a central bank policy error is imminent

By Yoruk Bahceli

(Reuters) – Bond investors could be in luck for the remainder of 2023 if market indicators prove correct, suggesting central banks are going to tighten too much and plunge their economies into recession.

Headline inflation has eased but underlying pressures remain high, prompting central banks to adopt a hawkish stance. Canada resumed tightening and the UK and Norway made big moves in June, while Federal Reserve and European Central Bank officials signaled further rate hikes at the Sintra Forum last week.

Markets are now expecting the Fed to hike rates by 25 basis points, likely in July, and see a 30% chance of another rate hike by November and have reduced the number of rate cuts expected next year.

They are pricing in two more ECB hikes to 4%, a change from the only hike to 3.75% they predicted in early June, while the Bank of England is expected to hike interest rates to close to 6.25%, much more than the 5.5%. previously expected.

Along with these bets, the inversion of the yield curve – in which shorter-dated bonds offer higher yields than longer-dated bonds, which is seen as a good sign that investors are anticipating a recession – has intensified as yields rise at shorter maturities.

US 10-year Treasuries are yielding 104 basis points less than 2-year Treasuries, the highest since the banking sector chaos in March and almost the deepest reversal since the 1980s.

Similar patterns can be observed for German and UK debt.

“The yield curve shows that this is very tight monetary policy,” said Mike Riddell, senior fixed income portfolio manager at Allianz Global Investors, which manages 514 billion euros ($558.31 billion) in assets .

“We are poised for a very large bond rally and believe risky assets are grossly underestimating the risk of a recession or anything bad,” he added.

“I fundamentally believe that this is a political mistake.”

BETTER YEAR

A policy overrun that central bankers had to reverse would be good news for global government bond investors who have been heaping bets on a fall in U.S. bond prices, according to CFTC data.

That means any shift in sentiment could lead to a strong recovery, boosting yields, which have come in at less than 2% year-to-date, after a 13% loss last year.

A first sign that bond prospects are improving came last week with data showing that business growth in the euro zone faltered in June. In response, German bond yields, which are moving in the opposite direction to prices, posted their second-biggest daily decline since March.

However, highlighting the difficulty of reading economic data, better-than-expected US first-quarter growth and German inflation pushed yields higher on Thursday.

Investors alert for a policy mistake fear central bankers are basing their decisions on inflation and other backward-looking data that has not yet shown the full impact of past rate hikes, and that they are overlooking signs of impending disinflation.

One indicator in focus is producer price inflation, which is seen as a harbinger of broader inflation. It fell to 1% a year in Germany and 2.9% in the UK in May, the lowest in over two years, and has fallen similarly in the United States.

“We all did a big thing around this time last year when (producer price inflation) was on the way up. But it appears to be being ignored on the way down,” said Viraj Patel, global macro strategist at Vanda Research.

Deutsche Bank believes the Fed may be “overcompensating” for the late start of rate hikes, citing improvements in the labor market, signs of an impending slowdown in rental inflation and tighter bank lending standards.

Such forward-looking numbers suggest economic data could change quite sharply, Vanda’s Patel said, adding that in all major economies any rate hike now increases the risk of policy failure.

Major central banks struggling to contain a surge in inflation have increased borrowing costs by over 3,750 basis points in aggregate since September 2021.

Difficult

Josefine Urban, portfolio manager at Britain’s largest investor Legal and General Investment Management, said she favored bets that UK government bonds would outperform their US and German counterparts.

The 10-year UK gilt yield is up 75 basis points to 4.43% this year, while US and German equivalent yields are little changed.

“We think the Bank of England (BoE) is mostly focused on lagged data, so it’s focused on inflation data, payroll data and jobs. There’s a pretty big risk that they’ll tighten monetary policy too much and we’ll “We’ll get the recession then,” Urban said.

Forecasts aren’t always accurate: at the end of 2022, 60% of economists polled by Reuters expected a US recession this year, but none has materialized yet, and risk assets that would be hit by a recession have barely batted an eyelid.

But even those not betting on a decline are cautious.

“Our baseline scenario is not that we will see a recession, but the risks are definitely increasing,” said Jill Hirzel, senior investment specialist at Insight Investment.

“Central bankers’ “priorities have been made very clear: if there is a risk of recession, they are willing to lower inflation,” Hirzel said, adding that she favors investing in defensive sectors and higher-rated corporate bonds.

($1 = 0.9206 euros)

(Additional reporting by Dhara Ranasinghe and Harry Robertson; Editing by Dhara Ranasinghe and Catherine Evans)

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