As global inflation prints continue to surpass expectations, investors have dialled up their focus on central banks, hanging on their every signal.
The European Central Bank (ECB), Federal Reserve (Fed), and Bank of England (BoE) are all taking slightly different lines, and to varying success.
European Central Bank
European government bond markets remain extremely volatile as the ECB attempts to provide forward guidance on a rate hiking cycle to tackle the inflation overshoots (both realised and forecast). At the same time, the ECB is looking to control for “fragmentation” in the eurozone sovereign bond market, where the likes of Greek, Italian and Spanish bonds see proportionally higher yield increases than countries such as Germany. At the ECB’s latest Governing Council Meeting last week, they signalled, as expected, an end to net bond buying in July. They also confirmed the intention to raise rates by 25bps in the same month and opened the door to a 50bps rate rise in September. This explicit commitment to raise rates, particularly putting a 50bps rise on the table and signalling of further rate rises to come, caught the market a little by surprise – German 10-year bond yields rose by more than 0.3% over the following three days to 1.75%, having spent 2019, 2020 and 2021 in negative yield territory.
A bigger disappointment to the market was the lack of clarification on what the ECB could or would do to tackle the fragmentation issue. Lagarde was explicitly asked to provide further details on this, but her vague and non-committal responses did little to re-assure the market that they had the situation under control – the spread of 10-year Italian yields over 10-year bunds increased by 40bps over the following three days, with the yield on Italian 10-year debt reaching 4.2% on Tuesday, a level at which the market starts to worry about the sustainability of Italian debt going forward.
These moves prompted the ECB into action: an emergency meeting was called, less than a week after the Governing Council’s meeting, to discuss the current market conditions. The mere calling of this meeting – an explicit acknowledgement that the ECB could be concerned about the dramatic increase in spreads – caused the market to retrace half of its widening. In the event, the conclusion of the meeting stressed the flexible options open to the ECB and the construction of a new anti-fragmentation tool. While not delivering anything new that the market shouldn’t have already known, it perhaps gave a clue as to what yield and spread levels could act as triggers for the ECB to take affirmative action. This did reassure markets and saw the spread between 10-year German and Italian debt tighten by around 30bps.
In contrast to this, in the US, the Fed was much clearer in its communication, directing the market to expect a 75bps increase in rates this week, and duly delivering it. While US yields have risen in the response to the tightening financial conditions, they have done so in a far more orderly fashion, with little or no market disruption. Clear communication of policy seems to be the Fed’s forte, at present anyway. As guided by the Fed’s communication, the market is pricing in a further 2% of hikes this year, with an implied Fed funds rate of 3.6% by the end of this year. As a result, we have seen the US yield curve flatten out at a rate of 3.30%, while US inflation assets have underperformed as markets seem to believe that the Fed are serious in their fight against inflation.
Bank of England
The BoE once again confused the market in its communications, which seemed at odds with its very recent monetary policy report. The Bank voted 6-3 to raise rates by 25bps to 1.25% (three voting for 50bps increase), and signalled that they will ‘act forcefully if necessary’. However, with inflation expected to peak at 11% later this year and currently running more than four times the BoE target, you need to ask the question: what are they waiting for? They stated that the labour market remains tight and that pay negotiations had been higher than they expected. If you couple with this an ever-depreciating currency and continued Brexit issues, then the slow reactions of the BoE could in fact be exacerbating the inflation problem.
The change in rhetoric from the minutes has seen a number of market participants revise their UK interest rate estimates higher, with many calling for 50bps hikes in the remaining meetings of the year. The market now has the Base Rate priced at 3% at year end. As a result, bond yields in the UK have continued to drift higher, led by the front end of markets. Equally inflation linked assets have underperformed on the assumption that the Bank will continue to raise rates, but that the BoE’s reticent nature has meant that UK assets have outperformed their global peers.
In this environment, rates funds have generally been well positioned to take advantage of rising yields, increasing country spreads and heightened volatility, all of which are favourable for active management. We are still of the view that yields could drift higher from here so we remain slightly short duration and underweight UK assets on a cross market basis, as we believe that the BoE will have to up the ante. In index-linked funds we are running yield curve flattening positions as we think that short-dated index-linked bonds will eventually come under pressure when inflation starts to slow – and as UK real yield assets are some of the most expensive in the world, we favour global real yields that are positive, such as Australia, US and Canada. We continue to favour short duration products and global diversification where possible.
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