As economies repair from the pandemic, unemployment has fallen, and inflation has risen. As key objectives for central banks, this has shifted the global monetary policy narrative to when, rather than if, central banks withdraw extraordinarily loose emergency settings.
One might have assumed markets would react by selling bonds in anticipation of higher market interest rates. That was certainly true in the first quarter this year, however, since then while many developed world economies have seen (marginal) increases in short dated market interest rates, longer dated interest rates have fallen significantly from their post pandemic highs.
Curve flattening a false signal?
We call this phenomenon a yield curve flattening (the gap between short and long dated rates narrows). While important for bond investors it also receives broader focus as historically it has frequently predicted the end of economic cycles. This time we think that it would be the wrong conclusion to draw. Instead, we outline below our base case for a resumption in the rise in longer dated market interest rates, led by US interest rates, as the year progresses.
The pathway to higher longer dated rates
US interest rates were a large driver of both the rise in long dated global interest rates earlier in the year and their subsequent fall. We will therefore focus our attention there and examine what underpins our base case for them to rise.
- Growth: It is clear the reopening of economies has been bumpier than hoped. Virus mutations (notably Delta), waning fiscal stimulus and capacity constraints have all been evident. China has also been tightening its economic stimulus. Nevertheless, high vaccination rates, combined with strong household and corporate balance sheets (spurring spending) and potential further government stimulus should contribute to extending above trend economic growth.
- Employment: Achieving true full employment across all demographics is key for the US Federal Reserve (the US central bank or “Fed”). Unfortunately, the recovery in employment has been more complicated than expected with apparent difficulty matching job vacancies to employees. Looking ahead this should improve as factors including the expiry of enhanced pandemic unemployment benefits, schools reopening and increasing wages all encourage people back to work.
- Inflation: Many central banks believe current inflationary pulses are transitory. It would appear the market has come to agree as market pricing of future inflation is close to unchanged over recent months. The risk remains high however that both are wrong. Indeed, the recent strength in consumer price inflation data has surprised central banks and market forecasters.
- Fed Funds Rate: In June Fed officials released their latest forecasts for the Fed Funds Rate (its key cash policy rate). The median of officials’ expectations moved to pricing an aggregate 0.5ppts of hikes in 2023, compared to no hikes through 2023 in their March forecast. While the pace of rate hikes may be slow, the Fed also continues to forecast that the longer term neutral Fed Funds Rate is 2.50%. This implies that current long dated rates are too low.
- Supply and demand: Demand for bonds has been strong since March. The Fed continues buying USD120 billion per month under its quantitative easing (QE). Other buyers have returned, notably US and global pension funds (buying bonds to de-risk after strong gains in shares) and banks (investing excess deposits into bonds given low customer loan demand). Issuance by the US treasury has also been lower than expected, and especially low in July. Going forward this supply should pick up while lower prevailing rates are now less attractive to investors. Most importantly, there are a growing number of Fed officials suggesting it is time to start contemplating reducing (tapering) of QE.
- Market positioning: By March global investors were underweight bonds. Further weakness in bonds (or higher rates) therefore needed new sellers. Strength in bonds over recent months has changed this picture with the market now more balanced, reducing the headwind to a move in either direction.
The pandemic means contemplation of a broad range of outcomes
Milford acknowledges this truly unique economic cycle ensures considerable risk around any forecast. As Nobel Physics laureate Niels Bohr noted “prediction is very difficult, especially if it’s about the future”. We also note that markets can be prone to overshooting. Arguably the pace of the first quarter bond sell off was too aggressive. Nevertheless, in aggregate Milford believes the reasons above provide a strong case for higher US and global longer dated interest rates, albeit likely to lower highs than we have seen in past interest rate cycles.