Calling the direction of interest rates from here is tough, even after central bank announcements this week.
- The Federal Reserve upgraded its view of inflation, but said it was primarily due to high energy costs and kept rates on hold
- Central banks may be willing to overlook short-term inflationary spikes
- Government bond markets may take matters into their own hands
The bond market doesn’t know what to do on interest rate expectations. Precious little clarity has emerged even as the UK and US central banks have made their announcements this week. The problem is that until central banks know whether there will be secondary inflation effects from the oil price rise, they can’t make a judgement.
The Federal Reserve made that clear. It upgraded its view of inflation, but said it was primarily due to high energy costs and kept rates on hold. This shows that unless higher energy costs start to spread to other areas of the economy, central banks may be willing to overlook inflation increases.
There are some reasons to believe that the second order inflation effects may not be as significant as they were in the wake of the Ukraine crisis. The labour market is tighter, for example, which may keep wage rises in check. Fossil fuel reliance has fallen. For the time being, the spike in energy costs is not as large.
However, the caveat is that central banks will be keen not to make the mistakes of 2022, when inflation was dismissed as transitory and they were slow to act. Three Fed committee members voted against the statement issued by the central bank, because it kept its forward-looking guidance on lower rates.
Max Stainton, senior global macro strategist at Fidelity International, said: “(Jay Powell) reiterated that the “majority” of the committee didn’t see the likelihood of hikes, and that the committee was still largely in a wait-and-see mode to assess how the ongoing shocks play out.”
The Bank of England is likely to take a similar approach, but its actions appear increasingly irrelevant to gilt markets. UK government bond markets appear to be focused on the potential for a change of prime minister in the wake of the local elections in May. They are increasingly pricing in a move to a more left-leaning government. The 2-year gilt yield is currently pricing in three short-term interest rate hikes, which only looks plausible in the scenario of a change of government and a debt crunch.
Luke Hickmore, investment director fixed income at Aberdeen Investments, says: “Bond markets are not casting a vote in May, but they are actively pricing what the outcome might mean. Political uncertainty translates into higher term premia, higher yields and ultimately a higher cost of borrowing for the UK. For fixed income investors, the conclusion is clear – politics is not background noise. In today’s gilt market, it is a fundamental part of the investment signal.”
Interest rates are very difficult to call from here. Even if central bankers are on hold, government bond markets may take matters into their own hands. Until there is greater clarity on the outcome of the war in Iran, investors will be left without any real direction.
