‘Policy mistake’ or ‘policy success’? How markets are reacting to rock-bottom rates
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Central banks were in the news this week, amid a busy round of policy meetings and market updates.
Those updates came in the wake of what’s been a jumpy month for global stocks, after bond markets started to rumble.
The rise in yields has prompted a rotation out of high-flying tech stocks, and left equity investors asking — where to next?
For their part, both the US Fed and Australia’s RBA have been direct in their latest commentary: Rates will stay on hold through to 2024, even as the economy recovers.
Those forecasts were accompanied by more strong economic data — most notably a booming jobs print on Thursday which showed Australia’s labour market is bouncing back from the pandemic.
When it comes to rising yields, one aspect to note is that the bulk of central bank intervention in government bond markets is taking place at the shorter end of the curve.
For example, the RBA’s yield curve control program works to cap three-year government bond yields at 0.1 per cent.
A by-product of those measures is that with yields rising (in response to stronger growth and possible inflation), the bulk of activity has taken place in longer-dated debt — most notably benchmark 10-year bonds.
That results in what’s known as a ‘steeper’ yield curve, where the yield on longer-dated debt is markedly higher than short-term bonds.
In a research note this week, CBA strategists Martin Whetton and Philip Brown said the divergence has brought two matters to the forefront which have been “hiding in the background for a while now”.
Firstly — on one hand, the market is pricing “what might be termed a ‘policy mistake'” by both the RBA and the US Fed, CBA says.
But on the other, it can also be thought of as a “‘policy success'”.
In the event that inflation was already above the target growth rate of 2-3 per cent, then the RBA’s commitment to keep front-end rates at rock-bottom could be deemed a policy failure, the pair said.
Right now, the view of both the RBA and the Fed is that inflation will rise through June off a low base. However, it’s unlikely to rise sustainably above three per cent in the medium-term.
And so long as inflation is merely higher than it has been — and not materially higher above three per cent — “we prefer to think of this movement as market expectations of policy success”, CBA said.
The second feature now coming back to the forefront is connected to the historic policy shift carried out by both the RBA and the Fed in 2020.
Instead of basing interest rates on where they thought inflation was heading, they now base it on actual inflation results.
In other words, inflation actually has to rise and stay elevated before rates change.
That policy shift makes it “much more likely that, should inflation rise, it will consolidate and become self-sustaining”, Whetton and Brown said.
Accompanying the jump in yields over the past month has been a rise in inflation expectations.
But along with that, it’s also given rise to a sharp increase in term premium — the difference between the yield on long-term bonds compared to short-term bonds.
A rise in the term premium mean investors are demanding more compensation (higher yields) for holding longer-term debt.
In CBA’s view, that demand for more yield isn’t so much to do with rising inflation expectations per se.
Rather, it reflects “an acknowledgement that the risk of a sustained bout of inflation is higher”.
And if actual inflation does pick up, it will probably serve to make the yield curve even steeper.
So on balance, “this change in term premium probably isn’t going away”, CBA said.
On the contrary, a possible “step-change” has occurred in bond markets, where the yield curve will remain steeper even as the economy recovers.
Why is that important for stock investors?
Since the start of the year, the yield on US 10-year treasuries (the global benchmark) has risen sharply, from ~0.9pc to above 1.7pc.
In the latest Bank of America fund manager survey, global money managers said they now view inflation as the main tail risk for markets.
In addition, they said a rise in US 10-year bond yields to two per cent would cause a 10 per cent correction in equities.
So as the post-COVID rebound picks up steam, “term premium” and rising yields are likely to remain a relevant theme for stock market participants.