(Bloomberg) - Bullish markets are increasingly pricing in a second-half reversal of the global monetary tightening wave, making it tougher for central bankers to vanquish inflation once and for all.
This year’s rally in bonds as traders bet on rapid policy pivots sent the average two-year yield down 30 basis points across the Group of 7 major developed economies, the steepest five-week plunge since early 2012.
The divide between central banks seeking to stay tough on inflation and markets betting on a policy reversal widened again this week, even as a trio of the world’s major central banks raised borrowing costs and spoke of doing so again.
The Federal Reserve slimmed its interest-rate hikes and acknowledged lower inflation prints while signaling it’ll probably take a “couple of more” hikes to get to sufficiently restrictive levels. The European Central Bank and the Bank of England similarly warned the inflation fight is far from done.
Bullish investors saw things differently, celebrating Fed chair Jerome Powell’s remarks that the disinflationary process has started. They especially welcomed the signal that his colleagues would have to adjust policy if inflation moves down faster than expected, even though he said that’s not his base case.
“The market is kind of playing a little bit of a game of chicken, hoping they can influence the Fed into cutting this year,” said Shana Sissel, Chicago-based founder and president of Banrion Capital Management.
She doesn’t see that happening as Fed officials “want to see inflation come down to their 2% target and stay there, for a few months, before they would even consider something like that,” Sissel told Bloomberg Radio.
Traders similarly ignored cautions from the BoE and ECB this week, instead acting on signs of economic weakening that they reckon will force a pause and then pivot toward interest-rate cuts.
The central banker-market dissonance is more than just a war of words. The bullish bets on a shift to rate cuts may in fact mean policymakers are forced to hold rates at higher levels for longer to achieve the tightening that investors are now actively undermining.
Three International Monetary Fund officials warned in a blog post this week that central banks needed to push back on markets and “remain resolute” without loosening prematurely or they risk a sharp resurgence in inflation as activity rebounds.
Still, some in markets are convinced they have it right.
“Central banks are talking tough — ‘higher for longer, the job’s not done’ — but once economies start to collapse because of the speed and magnitude of their earlier tightening, the market will price recessionary policy paths regardless of the level of inflation,” said Kellie Wood, a fixed-income money manager at Schroders Plc in Sydney.
“The bond market has got this cycle right and I believe it will get it right again on the way down,” she said.
Others have their money on central bankers to win the day. Bridgewater Associates founder Ray Dalio said that investors should believe Powell and the Fed, calling it “one of the easiest, safest bets” that you won’t see the easing the markets expect.
Rates traders have dramatically shifted their outlook over the past three months for what central banks will do, especially for developed markets.
Three months ago, overnight-indexed swaps contracts showed traders expected four developed-nation central banks to hike and just two would cut rates in the second half of the coming year, whereas the pricing was for eight cuts and a solitary, 10-basis-point increase in Japan, based on swaps data as of the end of trading on Thursday.
The picture for 20 key emerging markets was split in November with seven expected to raise borrowing costs and seven expected to lower them. Now, 12 are seen reducing rates and two are expected to increase.
The movement from investors is raising the stakes in a dramatic showdown with global central bankers, raising questions about whether and how officials should push back.
“The relationship to me feels a little bit like the Fed and folks making monetary policy are in many ways being influenced by the market and not wanting to upset the market and see a major selloff,” said Sissel. That’s concerning “because that’s not their job.”
A report from Deutsche Bank AG this week had a bit each way for those looking to the past for precedent.
History suggested a pivot to cuts “could arrive sooner than many realize,” strategist Henry Allen said of the Fed. “A fairly swift reversal would not be unusual by historical standards, particularly if a recession does occur.”
The Fed stopped hiking in 2018 only to reverse course seven months later. The ECB took just four months from its final increase of 2011 before it was cutting.
But today’s inflation picture differs. The Fed hasn’t begun reducing rates since the 1980s with the consumer price index excluding food and energy above 3%, while the last three ECB cutting cycles all began with core CPI below 2%.
“It’s clear that we still have a way to go on the inflation front before either central bank is at a point where they’ve historically cut rates,” said Allen. “And both are cognizant of the experience from the 1970s, when inflation returned after policymakers eased up too quickly.”
By Michelle Jamrisko and Garfield Reynolds
With assistance from Bryan Curtis
