As the gap between supply and demand tightened with economies reopening from the pandemic lockdowns, inflation rates in advanced regions trended higher in tandem with the recovery in economic activity. Relatively higher levels of inflation in such environments are somewhat tolerable given that the increased price pressures generally represent the temporary dislocations in an economy that is recovering from a recession.
However, more recent economic data shows that the slack brought about by the pandemic is being absorbed, meaning that economies have made substantial progress in re-establishing high levels of production capacity. This has been mostly evident in labour markets where the increase in employment resulted in unemployment rates declining to very low levels by historic standards in advanced regions. US unemployment declined to 3.6% in March 2022, the lowest since February 2020, while euro area unemployment fell to a record low of 6.8% in February 2022.
The broadening signs of price pressures when economies are approaching full capacity generally lead to a higher probability that central banks will tighten monetary policy, by increasing interest rates, and quantitative tightening, to keep prices stable. These price pressures have been exacerbated by the Russian invasion of Ukraine and the ensuing sanctions or embargoes on Russian exports, which resulted in increased disruptions in supply chains and lower availability of critical commodities. As a result, inflation in the euro area reached a record high of 7.5% in March 2022. US inflation soared to 7.9% in February 2022 due to higher energy prices, and yet the effect of the war in Ukraine has not yet impacted the headline rate.
High levels of inflation impact bond markets in two ways primarily. The first is the expected response by central banks of increasing policy rates in order to curb inflation and bring it closer to their target, typically 2%. The second effect is the higher inflation premia that investors start demanding given the expectations of high inflation. Both factors push bond yields (or interest rates) higher, and, conversely, bond prices lower.
Central banks have become decisively more hawkish at their recent policy meetings, recognising that more needs to be done to combat the high levels of inflation. Most notably, the Federal Reserve (Fed) has increased interest rates by 0.25% and indicated that it would increase rates by another 1.5% by year-end, with some participants also showing a willingness to hike rates in 0.50% increments.
The outcome of these meetings has resulted in economists and market analysts pulling forward the path for rate hikes, resulting in sharp increases in bond yields across maturities. The rise in benchmark bond yields, as well as the wider credit spreads given the increased uncertainty on the growth outlook due to the war in Ukraine, resulted in steep declines in bond prices, with the Bloomberg Global Aggregate Bond Index, representing global investment grade bonds, falling by 6.6% since the start of the year up to April 4, 2022.
The US 10-year Treasury yield rose from 1.51% to 2.40% during this period. When breaking down the move higher of 89 basis points (or 0.89%) since the start of the year, the vulnerability in the US Treasury market was a result of higher inflation expectations increasing inflation premia by 24bps, as well as higher expected short-term real yields given the faster rate hike trajectory of the Fed adding a further 62bps.
Higher inflation expectations have also driven euro area bond yields up, explaining most of the movement in the German 10-year Bund yield from -0.18% to 0.50% since the start of the year. Conversely, the European Central Bank (ECB) has maintained a much more cautious stance when it comes to tightening monetary policy. This is generally a reflection of fragmentation issues across member states that hamper inflation dynamics in the euro area as well as the seemingly weak pass-through effects from slow wage growth seen so far in the region.
Having said this, at its March meeting, the ECB communicated that it is looking at stopping its quantitative easing measures in the third quarter and to hike rates shortly after, given the sharp increases in inflation prints over the recent months. Despite this hawkish message, the market has failed to price-in a much stronger monetary tightening path. This seems to be out of lack of conviction that the ECB will be able to follow through because of the risks to the growth outlook given the war in Ukraine.
The move higher in benchmark bond yields in March, which followed signs of de-escalation in Ukraine, resulted in flatter yield curves as increased rate hike expectations have impacted short-term yields more than long-end yields. Market focus has shifted to the inversion in the US Treasury curve, where short-end rates traded higher than long-end rates, since this has historically been synonymous with increased recession risks.
Indeed, there is now greater concern that the extent of monetary tightening by the Federal Reserve to tame demand and discourage investment may potentially induce a recession. However, it should be noted that the initial conditions are substantially strong, as evidenced by key economic fundamentals.
There is now greater concern that the extent of monetary tightening by the Federal Reserve to tame demand and discourage investment may induce a recession
In the current environment, the flatter/inverted curves could be displaying a different story, that where markets are actually pricing-in an expected gradual decline in inflation rates. The accompanying tables show that the real yield curves, which represent yields adjusted for inflation, remain steeper as inflation premia taper down further out the curve. This could explain why the nominal curve is so flat early in the hiking cycle. While the inflation curve remains deeply inverted, the recession risks implied by a flat/inverted nominal curve is lower compared to previous hiking cycles.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi & Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.