The Week Transitory Inflation Ended

  • The Wall Street Journal – Central Banks Fuel New Bets on Tighter Money as Inflation Rises Globally
    Short-term bond markets have reacted to recent pivots by policy makers in Canada and the U.K.

    Stubbornly high inflation across more wealthy economies last week prompted a shakeout in bond markets as investors began expecting central banks to quickly tighten monetary policy. All eyes this week will be on the Federal Reserve, which is likely to begin winding down its $120-billion-a-month asset-buying program with an eye toward ending those purchases by next June. Markets show investors are increasingly betting on the Fed raising U.S. interest rates next summer, following recent inflation reports and signals from other major central banks that they are moving toward tightening policy.

  • The Financial Times – Bond traders ramp up bets on ‘big shift’ in global monetary policy
    Investors test central bankers’ insistence that elevated inflation will be fleeting

    Central banks normally dictate to the bond market. But now, investors are ramping up bets that policymakers have got inflation all wrong, and are forcing some to change tack. For much of this year, investors had swallowed central bankers’ mantra that there was no need to raise interest rates to combat a “transitory” burst of inflation. But an autumn surge in energy prices and the surprising persistence of supply bottlenecks in the global economy have sparked an increase in bets on earlier increases in borrowing costs.

  • The Financial Times – Bad bets trigger waves of tumult in short-term bond markets
    Some investors have been caught off-guard by vicious moves, say analysts
    A violent shake-up in bond markets has intensified as fund managers are wrongfooted by a global drop in short-term debt, say analysts and investors. Stubbornly high inflation around the world and a hawkish response by some central banks have fuelled a rapid rise in short-dated government bond yields. At the same time, concerns about growth prospects in the coming years have kept a lid on long-term bond yields, resulting in a dramatic “flattening” of yield curves. Short-term bond markets have “experienced unprecedented volatility” this week, said George Saravelos, Deutsche Bank’s global head of currency research. He said a sell-off in Australia’s market was the most severe since 1996, while Canada had been hit with its worst decline since 2009.
  • News – RBA waves white flag on bond yield target, so interest rates may rise sooner than expected
    Traders have forced the Reserve Bank into submission, with the RBA declining to enter the market to buy April 2024 federal government bonds to defend its interest rate target. The Reserve Bank has maintained a 0.1 per cent yield target on the three-year Commonwealth debt that matures in April 2024, but market traders have recently repeatedly pushed the return on those bonds substantially above that benchmark.
  • Summary

    In the last month, markets are pricing in more aggressive tightening monetary policy across the globe, sending short rates higher. This move accelerated in the last week. Is this signaling the end of the “transitory” inflation era?


    The last two weeks have seen short-term interest rates around the globe shoot higher, as the following series of charts show.



    This trend is most acute in Australia where it appears yield curve control is ending. The Reserve Bank of Australia cannot maintain its target of 0.10% (blue line).

    Recall our analogy from earlier this year. Central banks are a post and the markets are a horse tethered to that post. When the horse is spooked, it can rip the post out of the ground.

    It seems the horse has been more than spooked in Australia. It not only ripped the post out of the ground, but the entire fence!



    At the same time, U.S. investors are reassessing Fed policy. 

    The Chicago Mercantile Exchange’s Fed Watch tool offers a way to view the market’s thoughts on Fed policy. This tool uses the fed funds futures forward curve to calculate the probability of a rate hike at upcoming FOMC meetings. A probability over 50% signifies a rate hike is priced in.

    The chart below shows when the first rate hike is priced in, to a range of 0.25% to 0.50%. The cyan line shows the odds at the July 27, 2022 FOMC meeting first moved above 50% a few weeks ago. The green line, which shows the odds of a hike by the June 15, 2022, FOMC meeting, moved above 50% about 10 days ago.



    The CME’s tool can also be used to view the market’s expected timing of a second rate hike. The yellow line below shows the odds of two hikes by the November 2, 2022, FOMC meeting are now above 50%. Simply put, the market priced in a second hike in 2022 late last week. The red line, which shows the odds of a second hike by the September 21, 2022, FOMC meeting, is at 52%.

    Based on the charts above and below, the market is essentially pricing in a June 2022 rate hike followed by another in September.



    Finally, a third rate hike, which would put the fed funds rate in a range between 0.75% and 1.00%, is also a possibility. The blue line below shows the odds of a third hike by the February 1, 2023, FOMC meeting crossed above 50% last week. The odds of a third hike by the December 14, 2022 meeting are a coin toss at 48%.



    And what is driving these rates and market expectations of more hawkish policy? Ever higher expectations of inflation.




    Clearly, central banks set monetary policy. But we would caution the market is a powerful voice in the room with these central bankers.

    Right now that voice is sending a powerful signal that they need to get more aggressive in its view of rate hikes. The longer the market stays at these levels, which it only reached in the last week or so, the louder that voice becomes.

    History shows the Fed and economists often go through the five stages of grief before they accept a message from the market. Right now that message appears to be that the era of transitory inflation is over. We are now entering an era of more persistent inflation.

    If the market continues to push its current narrative, expect periods of denial, anger, bargaining, depression, and then finally acceptance from the Fed. 

    The market is offering its opinion. Right now it is showing signs of concern that central bankers are behind the curve.