The bond market is dialing back expectations for how quickly and steeply the Federal Reserve will raise interest rates as Russia’s war in Ukraine threatens to exert a drag on global economic growth.
Money-market traders have priced out any risk that the U.S. central bank will start its tightening campaign this month with a half-point increase, which was once seen as a near certainty, and even a quarter-point move isn’t completely assured. At the same time, they have also marked down where the Fed’s benchmark rate will peak to around 1.7%, a drop of over 20 basis points from previous expectations and well short of the central bank’s 2.5% long-term estimate for the rate.
The repricing shows how much the geopolitical uncertainty has shifted the balance of risks facing the world’s monetary-policy makers, who now need to weigh the prospects of slower growth even as rising energy and commodity prices threaten to fuel what’s already the highest inflation in four decades. The move in U.S. markets is being mirrored in the U.K. and Europe, where traders have also dialed back rate-hike bets.
“This is a significant increase in the stagflationary winds blowing through the global economy,” Mohamed El-Erian, chief economic adviser at Allianz SE and a Bloomberg Opinion columnist, said on Bloomberg Television. “The marketplace has been coming down to a more reasonable amount of tightening. But what the marketplace hasn’t recognized is the reason why the Fed will tighten less. It’s not because inflation has a better outlook. It has a worse outlook. It’s because growth has a significantly worse outlook for the global economy.”
Treasury yields have tumbled in the wake of the Ukraine war, in part due to a rush into the most liquid investment havens. But rates on inflation-adjusted Treasury yields, dubbed real yields, have also plunged as growth prospects dimmed and bond-market gauges of short-term inflation expectations hit all-time highs.
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The rapid reversal has some investors questioning whether the pullback in yields is overdone and whether the uncertainty cast by the war will actually alter the path of central banks seeking to tamp down inflation. Some of the price moves may also have been exaggerated by a rush to cover bets against Treasuries that were upended when prices rallied after the Russian invasion.
James Athey, investment director at Aberdeen Asset Management in London, is wagering against those thinking the war could totally upend the Fed’s tightening plans. He expects that any delayed rate hikes this year will just be shifted into 2023 and said the drop in yields is more about some traders getting caught off-sides with short positions.
“This is a position squeeze,” he said.
“Central banks were being forced to tighten by high inflation and high inflation expectations, not by high, rising growth or rising real wages,” he said. “So the fact that this Russia situation is probably bad for growth and bad for risk sentiment doesn’t provide any excuse whatsoever for central banks to dramatically change course.”
The market is now pricing in less than five quarter-point rate hikes from the Fed this year, compared with more than six such increases two weeks ago. Traders are betting the Fed may raise the borrowing costs by less than 50 basis points next year before starting to cut in 2024.
The increased inflation pressures and growth risks have sent U.S. real rates plunging. The rate on five-year Treasury inflation-protected securities -- known as TIPS -- is around negative 1.7% versus being less than negative 1% just a few weeks ago.
The two-year breakeven inflation rate, which measures the gap between TIPS and plain vanilla Treasuries, surged last week to the highest since Bloomberg began compiling the data in 2004. It’s hovering just below that now at about 4.28%, up from some 3.2% at the end of December. The five-year breakeven is at 3.30%, up from 2.89% at the end of January.
Two-year Treasury yields, which had more than doubled between the end of last year and mid-February to 1.64%, have since retreated by over 30 basis points.
Part of the revamped calculus for traders involves the possibility that if the Fed starts out less aggressively this year it may be forced to catch up in 2023 -- all the while avoiding driving the policy rate so high that growth grinds to a halt.
“The Fed may go less aggressive to start, then have to make it up further out, with the market also saying overall the Fed will do less,” said Priya Misra, global head of rates strategy at TD Securities Inc. “This may be related to concerns over the global credit exposure to Russia and the risk it tightens financial conditions a lot -- as well as growth concerns. And even before Russia, the bond market was worried about the strength of the economy next year and beyond.”
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