We’re barely into February and financial markets are already starting to walk back the dominant new year narrative.
Not unlike 2021, when a cranky first quarter gave way to a more serene year for all assets, there are twitches of a rethink after just a month of 2022. Detecting some waver in what at first looked like a draconian anti-inflation shift across all major central banks, investors are wary it may all have been a bit overdone.
In the space of just six weeks – marked by alarming inflation prints, a shift in central bank rhetoric and only a glancing economic blow from the Omicron wave of COVID – interest rate markets went from pricing just two U.S. Federal Reserve rate hikes this year to more than five.
Some banks, such as Bank of America, rushed to forecast as many as seven – or roughly one at every policy meeting.
Not only that, but there’s now an assumption the Fed will also move to unwind its bloated balance sheet in 2022 – whereas previously it had been pencilled in for the following year at the earliest. The combination added half a percentage point to benchmark 10-year Treasury yields in the month to mid-January.
Even though all that expected tightening still wouldn’t get the Fed back to prepandemic policy settings, the jolt to runaway stock markets was sizable. Despite a late two-day rally, January was still one of the worst half dozen months for the Nasdaq since Lehman Brothers went bust more 13 years ago.
But as February kicks off, the mood is different – even without a change to what’s priced for central banks this year. There are still five Fed hikes for this year baked in, along with a quarter-point rise by the European Central Bank and almost 1.25 percentage points of Bank of England tightening.
Asset managers fear bumpiness will prevail all year despite some calm now. “Despite the solid growth context, markets will trade sideways amid bouts of risk aversion followed by tactical rallies,” said Unigestion portfolio manager Olivier Marciot.
But the real rethink is still coming around what happens after this year.
Longer-term futures prices that show the peak in short-term interest rates around the winter of 2024/25 have now slipped back below 2 per cent – a full 50 basis points below where the Fed sees this so-called “terminal rate” and almost 20 bps off January’s highs.
The “real” inflation-adjusted 10-year Treasury yield has also dropped back from prepandemic levels and shed almost 25bp in less than two weeks to -0.75 per cent. And that yield has not been positive on a sustained basis since before COVID hit.
And aside from the euro zone, where the least amount of tightening is priced for this year, two-to-10-year yield curves – the gap between yields on both maturities and often seen as harbinger of growth or recession ahead – are flattening fast.
PUSHBACK
Why so glum?
Long-standing questions remain over how much tightening these economies can now absorb, how long the global inflation spike lasts, the net damage to demand from energy price squeezes and even the willingness of central banks to seed another recession or crimp government funding at this juncture.
But the long-term rates recoil is also feeding off the incoming “Fedspeak.”
On Monday, San Francisco Fed chief Mary Daly told Reuters that the Fed was poised to start raising rates in March. “But after that, I want to see what the data brings us,” she added.
Ms. Daly’s not a voting member of the Fed’s policy-making council this year. But Kansas City Fed chief Esther George, who is a voter in 2022, also spoke on Monday and warned of uncertainties: “It is in no one’s interest to try to upset the economy with unexpected adjustments,” she said.
The release over the past week of the White House list of nominees to vacant Fed Board positions - all voting policymakers – could also add a dovish hue to thinking.
Small wavers perhaps but enough for a pause for thought.
The Reserve Bank of Australia struck a similar note on Tuesday, ending emergency bond buying as expected. But it pushed back hard against aggressive market pricing for a first rate hike as soon as May and more than a percentage more by yearend and insisted it was willing to be patient.
This week’s ECB meeting is likely to underline inflation risks and its planned withdrawal of emergency supports. But it has for months pushed back against pricing for a rate rise as soon as this year and will likely do so again.
The Bank of England meeting this week will be more hawkish, with a likely second hike in U.K. interest rates since December. But with 100bps more of rate rises already priced by yearend, a lot is already discounted.
And then there’s the oil price – and a whole series of risks such as a possible Russian invasion of Ukraine.
Part of January’s rate shock was down to a near 20-per-cent rise over the month in Brent crude prices that stymied hopes for a quick collapse in the annual rate of energy price increases feeding decades-high headline inflation rates.
Tension around Ukraine could well see prices spike even further of course. But any signs of more diplomacy and detente could also change that picture rapidly too.
In the end, markets always ebb and flow – modelling and pricing best and worst case scenarios to extremes.
But given that reality often ends up being somewhere in between, the sooner they hit those extremes the quicker the rethink.
The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own.
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