LONDON, Dec 5 (Reuters Breakingviews) – Words are fighting it out with numbers in financial markets at present. Comments by central bankers underline their desire to keep interest rates high until price growth quiesces. Traders, however, are paying closer attention to falling inflation figures, sending bonds higher in the expectation of lower borrowing costs. Policymakers’ recent mistakes mean they will struggle to convince investors their tough talk is real.
U.S. Federal Reserve Chair Jay Powell says his fellow policymakers are “not thinking about rate cuts at all”. Christine Lagarde, the European Central Bank president, insists she will not ease monetary policy for at least “the next couple of quarters”, while Bank of England Governor Andrew Bailey has vowed to do “what it takes” to bring inflation down to Britain’s 2% target. The titans of central banking could not have been clearer: having hiked borrowing costs to multi-year highs, they intend to keep them there until consumer price growth comes back down to earth. Unfortunately, investors don’t appear to have got the message.
Western bond markets have been on a tear, powered by investors’ belief that falling inflation and economic weakness will force Powell and his colleagues to backtrack further and faster than they expect. November was the best month for U.S. bonds since May 1985, according to Deutsche Bank analysts, while global bonds had their best monthly performance since December 2008. The yield on the world’s most important sovereign credits – 10-year U.S. Treasury bonds – fell from nearly 5% in October to 4.3% in November, the biggest monthly decline since July 2021 . Yields on two-year Treasuries, which are more responsive to official rates, have fallen from 5% in July to around 4.6% today .
The drop in yields, which move inversely to bond prices, reflects rapidly shifting expectations. Markets now believe that there is a near-50% probability the Fed will cut rates in March and an 80% chance it will act in May, according to derivatives prices collected by LSEG. That was hard to imagine as recently as a month ago. The same thing is happening in the euro zone. In defiance of Lagarde’s statement, investors ascribe a more-than-even chance the ECB will cut rates in March and believe there is only an 8% probability official borrowing costs will still be at the current level of 4% in April.
The disconnect matters beyond policymakers’ pride and traders’ bragging rights. If central bankers are true to their word, bond markets will suffer a reversal, exposing investors, banks and companies to painful losses on their debt holdings. The near-collapse of several UK pension funds in September 2022 and the failure of Silicon Valley Bank in March are two recent examples of the financial damage sharp moves in bond prices can do.
But if investors continue to believe in early rate cuts, they will make life even more difficult for Powell, Lagarde and Bailey. Lower yields encourage companies and households to take on more debt. That, in turn, can drive more production and consumption.
Investors have been wrong before. In May, after another U.S. regional bank failure, markets concluded that the Fed’s rate hike at the beginning of that month would be its last. The yield on two-year Treasuries dropped to 3.7%. As the month wore on, unemployment fell to a 53-year low and inflation remained high. By the end of the month, two-year Treasury yields were nearing 4.6%.
Yet central banks are once again struggling to get their voices heard. That’s partly for objective reasons: inflation has been falling more rapidly than expected. In the United States, the core personal consumption expenditure index, which excludes food and energy prices and is the Fed’s preferred measure of inflation, rose by 3.5% year-on-year in October – the slowest pace since April 2021. Over the past six months, core PCE has grown at an annual pace of around 2.5%, not far from the Fed’s 2% target.
In the euro zone, headline inflation dropped to 2.4% in November from 2.9% a month earlier, within shooting distance of the ECB’s goal. It was the third straight month that consumer prices grew by less than market expectations. UK inflation fell to 4.6% in October, from 6.7% in September, the biggest monthly fall since April 1992.
Respected central bankers might be able to convince markets that these numbers don’t portend imminent rate cuts. But the current crop of rate-setters failed to anticipate the inflationary spike. Powell blew a hole in the Fed’s reputation by insisting that the inflation sparked by the pandemic was a “transitory” phenomenon until late November 2021. At the time, the core PCE index was growing at 4.7% a year, the fastest pace since the 1990s. The Fed waited four more months to sanction its first hike. By then, Russia’s invasion of Ukraine had pushed prices up further.
The BoE moved faster, first raising borrowing costs in December 2021, but has since been terrible at forecasting inflation. Its projections underestimated the actual numbers by an average of 6 percentage points between December 2021 and March this year, according to Breakingviews calculations based on data collected by Berenberg analysts. Bailey acknowledged the problem in July when he asked former Fed Chair Ben Bernanke to review the BoE’s forecasting methods. As for the ECB, at the end of 2021, it predicted that inflation in 2022 would be 3.2%. It came in at nearly three times that level.
There are extenuating circumstances. The huge fiscal stimulus doled out by governments during the pandemic fuelled unusually high spending on goods by locked-up consumers. As that inflationary wave was waning, the Ukraine war upended supply chains and energy markets, leading to spikes in the prices of food, electricity and many services. Nevertheless, central banks’ old-school models failed to factor in these price shocks.
Now markets are betting policymakers will commit a symmetrical sin by crying wolf over persistent price pressures just when inflation is fast disappearing. Central bankers could, of course, admit they cannot micromanage financial markets. But that too would damage their inflation-fighting credentials. Still, as Jacob Frenkel, a former Bank of Israel governor, told reporters recently, for policymakers “humility is the name of the game”.
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CONTEXT NEWS
U.S. economic activity slowed from early October through the middle of November, while businesses reported inflation largely moderated and it was easier to hire workers, the Federal Reserve said in a report on Nov. 29.
“Economic activity slowed since the previous report,” the Fed said in its survey, known as the “Beige Book”, which polled business contacts across the central bank’s 12 districts through Nov. 17. “The economic outlook for the next six to twelve months diminished over the reporting period.”
In the euro zone, inflation fell far more than expected in November, fuelling market bets on early spring rate cuts in defiance of the European Central Bank’s explicit guidance. Consumer price growth in the 20 nations sharing the euro was 2.4% in November, down from 2.9% in October and well below expectations for 2.7%, according to official figures released on Nov. 30.
Editing by Peter Thal Larsen, Oliver Taslic and Thomas Shum
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