The dangers of complacency
Michel Vernier, CFA, London UK, Head of Fixed Income Strategy
- Is the rates market right to be confident that inflation will cool quickly, or is it being too complacent?
- A peak in the US policy rate of around 5.5%, if not more, seems likely this year
- Interestingly, the average policy rate 24 months after rates peaked has been around 60% of that level since 1972
- Rates markets can react swiftly. As such, locking in yields at current levels seems a sensible strategy
Complacency has been rife in bond markets. First it was the US central bank over its ability to control (transitory) inflation in 2021. Then, during recent months, it has been the rate market presuming that inflation would reduce quickly. Where might the next dose of complacency pop up and what might it mean for bond investors?
Complacency and errors
Back in 2021, it was the US Federal Reserve (Fed) which, in hindsight, was too complacent about its ability to control inflation, arguing for too long that the phase of higher inflation would be transitory.
Since then, the central bank has corrected its path and initiated the fastest hiking path for the US policy rate since the 1980s, while maintaining a very hawkish tone: “will keep at it until the job is done,” said Fed chair Jerome Powell in September, referring to the 2% inflation target.
From September until the US job market data released early in February, complacency was witnessed in the bond market. The decline in 2-year yields, by one percentage point, in the UK and the US over the same period reflected the market’s overconfidence in expecting a rapid decline in inflation already after the first signs that inflation was easing.
During that period, the rate market not only priced in a lower peak policy rate, but also early rate cuts in 2023; this despite the Fed leaning strongly against such euphoria and despite the risk of stickier inflation.
The market’s complacency seems to have faded, after recent data pointed to sustained tightness in the US job market, a key driver of future inflation. We have pointed to the risk of a slightly higher peak during the last months and with tighter job market data we see a very good chance of a policy rate of 5.5% at a minimum.
Inflation is likely to be stickier
The disinflation party (with fast-falling rates and tighter spreads) may gradually come to an end, as the dominating disinflationary pressures from the goods component of inflation run out of steam, while the stickier core inflation components are still to feel the full force of higher rates.
Such a transmission may take some time and the bond market, up until February, seemed to have turned a blind eye towards to this possibility. We pointed to this scenario in The road to normalisation for bond investors?
“The bond market, meanwhile, seems to expect a different scenario, which appears optimistic on two levels. First, it does not price in the possibility of a higher peak in inflation. Second, the rate market anticipates rate cuts less than six months after the peak, something that we believe is not on the Fed’s agenda. Of course, risk of a severe downturn remains, together with the possibility of a partial unwinding of the rate hikes. But to get there, we believe the fed fund rates potentially need to peak even higher than is being priced in at the moment.”
Continued re-pricing likely
The next few weeks or months may see more re-pricing of the peak policy rate, which we forecast to be 5.5%, while some upside risk remains. Overnight indexed swaps (OIS) forwards are pricing in a peak rate of 5.25%, with a slight chance of 5.5%.
Meanwhile, the longer end of the yield curve may continue to re-evaluate future rate cuts. During the last three months the rate curve has already priced out roughly two rate cuts by February next year, for example. This transition from complacency to reality (no early cuts) may cause some volatility going forward again.
Does this mean that our preferred theme of locking in yields at this point in time is no longer appropriate?
The answer is no. Although the risk of a somewhat higher peak seems skewed to the upside, the Fed may eventually hit the brakes for fear that the economic repercussions of getting it wrong are too severe.
Alternatively, it may be the central bank’s almost stubborn (and up until now necessary) hawkishness may prove to be another breeding ground for complacency as overconfidence in being able to cool inflation, while achieving a soft landing for the economy, proves misplaced. Time will tell.
Next complacency in the making
A soft economic landing and inflation heading back towards its 2% target is a desirable outcome. But previous cycles show inflation only cooled in most cases after a substantial slowdown, if not only after a recession.
As such there seem to be two possible scenarios: The first involves an economic slowdown, with inflation moderating and finally rate cuts towards next year.
The second scenario, which deserves consideration, is one where the economy is more resilient than expected and inflation remains elevated for longer than predicted. In such a case, the Fed may need to add even more hikes than currently anticipated in order to force a slowdown. Dallas Fed President Lorie Logan provided some flavour about the Fed’s thinking with regards to such a scenario1:
“We must remain prepared to continue rate increases for a longer period than previously anticipated, if such a path is necessary to respond to changes in the economic outlook or to offset any undesired easing in conditions.”
But as outlined earlier, the Fed may be complacent to believe that excessively higher policy rates will not take their toll. As such, the pressure to cut rates subsequently to the last scenario, may be even greater. Whichever scenario materialises, it may point to the central bank taking a more accommodative policy stance within the next two years.
Peaks rarely last forever
The following table examines the last ten rate hiking cycles since 1972. While a discussion about the long equilibrium rate and inflation trend is important, the table makes one point very obvious: Central banks react to economic conditions and hiking and cutting rates are part of the policy process.
Extrapolating from short-term trends rarely works with the presence of cycles. Certainly, each observed cycle has had its own triggers and characteristics.
However, rate-hiking cycles do not last forever. While the timing of peak policy rates has varied (also depending on the definition of when a hiking cycle starts and when it ends) the average peak policy rate lasted for only six months on average. More importantly for bond investors, the average policy rate 24 months after rates peaked was only around 60% of the respective peak level on average (see table).
Interestingly, the traditional rate-cycle pattern has been regularly ignored by the rate market in the past. As the next chart shows, the 2-year US Treasury yield has been significantly lower than the peak policy rate, three years after the peak was reached, since 1983. In addition, the 2-year rate was significantly lower than the market-implied 2-year rate would be three years after the peak rate was hit.
With this in mind, what can bond investors do?
For now, the risk seems skewed towards a somewhat higher and potentially longer peak (see next chart). Using the current phase of re-pricing (transition from complacency to facing reality) to lock in yields seems a sensible strategy currently. Especially given that rate cuts, even if not this year, are on the way.