Rates Spark: Low rates puzzle

There are plenty of opportunities this week for rates to wake up to the risk of earlier central bank tightening, most prominently from the Fed, but the current mood is one of despondency when it comes to reflecting better economic prospects. The puzzle presented by low rates even as inflation expectations are adjusting higher is not an easy one to solve.

Our first instinct would to assign their inability to rise to depressed economic expectations but one has to factor in the fact that exceptional degree of uncertainty about medium term expectations make such reading difficult for long-dated interest rates. Worse still, some market indicators such as inflaiton swaps point to a healthy economic outturn for the next ten years.

Stability draws more buyers in, thus creating a self-reinforcing dynamic

Dismal economic expectations may be justified, as interest rate investors reflect on the past decade of anaemic growth inflation and could be tempted to extrapolate. The inability to gain a satisfactory degree of confidence when making economic predictions beyond a few years means ones has to factor in flow and risk sentiment in making interest predictions. Using this approach rather than economic fundamentals yields an altogether different insight: stability draws more buyers in, thus creating a self-reinforcing dynamic. The same goes as markets are able to shrug off more inflationary warning signs and hawkish soundbites.

It is tempting to say that this reasoning applies to today's ISM services and tomorrow’s FOMC minutes. Rates markets seem to have grown numb to the risk of the Fed being forced into tightening policy more abruptly than it would like to by higher inflation. This may be a reflection of the market’s tendency to derail tightening expectations but the proximity to a tapering announcement later this quarter raises the stakes around Fed communication.

Should the current market mentality continue, more hawkish soundbites should mostly affect the short-end of the curve, as investors not seem to believe in its ability to tighten policy beyond a short-lived cycle taking the terminal rate around 200bp, compared to 250bp in the Fed’s forecast, and 225bp in the previous one.