Rates Spark: The hangover

Current markets are characterised by a sell-off in almost every asset class, regardless of its degree of riskiness. Phases of negative correlation between bond yields and stock prices are relatively rare, and typically characterise regimes where inflation, rather than growth, expectations drive investors’ behaviour. To illustrate this point, the relentless rise in European energy prices, for instance natural gas and baseload electricity, as well as last week’s jump in UK inflation, have put price pressure back on the agenda. This in turn is prompting fears of central bank tightening, and so driving both bond yields up, at the safer end of the risk spectrum, and equity prices down, at the riskier end. In regimes where growth is the primary concern, or when inflation concerns ease, bonds regain their safe-haven characteristics, and their yields correlate positively with riskier alternatives.

Risk appetite is understandably in short supply as central banks struggle to get on top of inflation

All this is an attempt to make sense of the generalised rout in financial markets, but also to identify where it may end. Risk appetite is understandably in short supply as central banks struggle to get on top of inflation, but there is hope. For one thing, the surge in inflation expected over the coming months is mostly a regional development. Short-term EUR and GBP inflation swaps react to ever higher energy prices but their US counterpart have cratered. In periods of high volatility, it is understandable that the jump in European yields should push their US equivalent higher, but this dynamic has its limits. And indeed, we’ve seen a large divergence between EUR and USD bond yields already.

The current unstable equilibrium can be resolved in one of two ways. In the Goldilocks/soft landing scenario, tame inflation expectations reassure investors that at least the Fed will balk at hiking rates too high thus maintaining hopes of a soft landing. This should ultimately draw a line under the bond market rout. In the European scenario, lower growth expectations, which could worsen after today’s PMIs, mean risk assets continue to underperform, thus directing safe-haven flows to bonds. This second scenario has an assumption baked into it, that European central banks will refrain from tightening policy in the midst of a severe recession. This is our view but one of the reasons for assets of all risk flavours selling off is the doubt that persists about their willingness to do so.

The Treasury curve should re-steepen on a relative basis, while its German counterpart converges to it

A clear objection to this simplistic view of the world is that markets should be able to have more than one concern at once, but we doubt that this is true if one looks at outright yield levels. This point is relevant for the shape of the curve, however. In places where the growth outlook is the most concerning, Europe, and where inflation looks most likely to spin out of control, Europe again, one would expect the curve to flatten. It is most interesting that the US has just seen a similar flattening move in the past few months, meaning the Treasury curve should re-steepen on a relative basis, while its German counterpart converges to it.