One of the psychic downsides of being a risk manager is that it is part of the job description to continually forecast “bad things happening” but being unable to take any satisfaction whatsoever when said forecasts become reality. A few weeks back, I was musing if yield curves were getting interesting again. In reality I was only half right as it is only the front end of yield curves that have definitely become interesting. That in itself is somewhat worrying.
To get up to speed, the Fed is now seriously concerned about inflation, February inflation printed at 7.9%. This has led to forecasts multiple rate hikes in 2022, 2023 and 2024 with a forecast peak of rates (this cycle) at 2.79% in June 2024. In the UK, the inflation print was 6.2% in February. As such, the MPC raised rates last week to 0.75% with a forecast peak of rates 2.42% in September 2023. The Swedish central bank has described inflation as “far too high” and the markets are expecting the first post-pandemic rate risk by September at the latest. As usual the outlier is the ECB, where concern over inflation is common, the February print was 5.9%, but action less so. Euribor is forecast to hit 0% by December 2022, reaching a peak if 1.215% by March 2027…
What is disturbing is that the long ends of global yield curves are pricing in almost zero inflation. Long dated USD forwards are at 2%, in the UK 1% and in the Eurozone 0.5%. What this is telling you is that the market thinks that global economies are so weak that any small increase in short term funding rates will be sufficient to kill any growth / inflation over the long term. If this is true it is a disturbing conclusion that the last 10 years on the drip feed means one can never leave the drip. The problem with this forecast however is that inflation is a tricky beast. We know that energy prices have risen, they may rise further and they may stay high for more than the, currently forecast, short term. In addition, we know that supply chains, disrupted by Covid are being put under further strain by geo-politics and de-globalisation is inevitably inflationary. And lastly, people remain consistent with their nature. Wage hikes to offset inflation all sounds a bit last century, but if they start and become entrenched, further inflation is just around the corner.
As usual history does not repeat, but it could rhyme. In the 1970s stagflation was the name given to the rather toxic combination of low growth and high inflation that ravaged the global economy. This was finally brought under control when Fed chairman Volcker raised short term rates sharply, with the prime rates hitting a peak of 21.5% in 1981. At the same time US 10yr Government bond yields were hitting their peak of 15%, after which they entered, what was effectively, an almost forty-year bull run.
The risk here is that current inflation is real and may become embedded. Further central banks have a far more explicit inflation beating mandate today than was the case forty years ago. Lastly, the central banks do have a playbook that did work last time. None of the above is good, but to my mind, the larger risk is the current state of the bond market. Since the bottom about a year ago, long-term rates have risen about 100bps. Not coincidentally, Bloomberg has a story yesterday how a global bond index has had its largest sequential drop, more than 10%, since it was constituted in 1990. At the current very low level of yields, a 100bp rise in yield will result in another 9% loss. Fixed income portfolios are meant to be boring. Losing more than 20%, with the prospect of losing more, remember even at that point the coupon is still only 3%, is a bit too interesting for most folk. If global investors determine that the risk reward ratio of long dated fixed income is wrong, stay out of their way. It will get messy.