Yields on short-dated notes have moved sharply higher in recent weeks, while those on longer-dated bonds have fallen modestly in many countries. This flattening of yield curves has come in response to worries about inflationary risks potentially being more persistent in the near term and lasting longer than previously anticipated.
The speed and magnitude of this repricing suggest investors expect central banks in developed countries such as the U.K., U.S., Australia, and Canada to start tightening monetary conditions sooner and at a swifter pace than previously thought. Many investors are left wondering what to expect from the next stage of monetary policy.
Despite the recent volatility, market pricing still indicates a belief that central banks will act in a credible manner to keep inflation expectations well-anchored. Long-term inflationary expectations have also remained relatively stable.
Flattening forces emerge
Flattening of yield curves typically occurs relatively later in an economic cycle as investors expect central banks to raise short-term policy rates, which pushes up short-dated yields relative to longer-term ones. Yield curve behavior can thus foreshadow changes in monetary policy and the economic outlook.
Much of the recent change in market thinking relates to questions about the persistence of supply chain disruptions and supply-demand mismatches in various sectors as the global economy emerges from the COVID-19-driven slowdown. With some inflation metrics remaining elevated, market participants are envisioning a more imminent reduction in quantitative easing, with interest rate hikes on the horizon.
The recent moves in the front end of interest rate curves have led to a deleveraging of many traditional fixed income relative value and carry-focused strategies globally. This includes hedge funds reducing risk exposure after losses caused by the rise in front-end rates, including buying back their short positions in the long end, furthering the flattening effects.
With the rise in volatility and transaction costs, traditional intermediaries and existing market structure have made it difficult for true liquidity providers to support the market and ease these dislocations. Indeed, the extent of dislocation across yield curves is the greatest since March 2020.
On one hand, broader curve flattening and shorter economic cycles are consistent with our secular view that economic cycles are likely to become shorter and of greater amplitude than in the past, and may involve a comparatively early withdrawal of monetary accommodation. Yet in our view, the extent of the recent flattening suggests markets may have shifted too abruptly.
Like the markets, many central bank officials have also seemed to change their tune on inflation. For much of this year, they suggested the accelerating inflation showing up in economic data was transitory. Now, central bankers are questioning this thesis, and concerns have arisen that the higher realized inflation may start filtering into longer-term inflation expectations.
For example, in the U.K., recent market pricing anticipates more than one 25-basis-point (bp) rate hike before the end of this year, and that the Bank of England’s (BOE) policy rate will be in the range of 1.25%–1.5% by the end of 2022. A year ago, 90-day sterling futures were priced for the BOE to lower its policy rate below 0% by the end of 2022.
Sentiment shift may be too rapid
Although we agree with the basic direction of the recent shift in sentiment, we think market expectations might be moving too quickly, for several reasons.
First, forward inflation expectations as embedded in inflation-linked securities see inflation beyond our cyclical horizon – roughly the next year – broadly consistent with central banks’ mandates.
Second, though central bankers will likely act to preserve inflation expectations, they are acutely aware that monetary policy is not the best tool to address upward price pressures emanating from a shock or disruption to the supply side of the economy.
Third, tail risks – or the possibility of unforeseen outcomes – from COVID-19 have diminished but haven’t gone away, and employment in most economies is still well below pre-pandemic levels. Though a well-calibrated withdrawal of monetary stimulus will be necessary, central banks are eager to continue supporting recovery in labor markets, and thus will not be keen to tighten too rapidly.
Change can create opportunities
The risk premium associated with the outlook for rate hikes may be more long-lasting at this point, meaning that the market’s anticipated path for monetary policy may continually overestimate the actual path because of recent yield curve moves and concerns about inflation expectations.
The rapid repricing of expectations has often resulted in good return-generating opportunities, as excessive risk premium becomes embedded in the front end of yield curves. Active investment management can help weigh risk/reward characteristics, as well as seek to take advantage of opportunities emanating from this curve repricing and the evolving central bank pivot from extraordinarily accommodative policy to potentially late-cycle dynamics.
For PIMCO’s latest Secular Outlook, please read, “Age of Transformation.”
Sachin Gupta is a portfolio manager and head of the global desk. Rick Chan is a portfolio manager focusing on global macro strategies and relative value trading in interest rates.