After incredible volatility in government bond markets last week, the Fed, the Reserve Bank of Australia (RBA) and the Bank of England (BoE) are all due to deliver monetary policy decisions this week, setting the stage for another turbulent few days in rates. In our view, the BoE will take centre stage in the minds of investors.
If this weren’t enough, the week also concludes with the release of the perennially important Non-Farm Payrolls data in the US, which includes the unemployment rate, participation rate and Average Hourly Earnings. All three components have become essential ingredients for strategists to shape their tapering and rate hike expectations.
To recap the reasons for the moves observed last week, the Bank of Canada acted hawkishly by ending its QE programme early and dragging forward its hiking policy, and the RBA failed to defend its 0.1% short term yield target (Apr 2024 bonds rose to 0.80%), causing short dated yields to rise. Likewise, with traders in the UK aggressively building rate hike expectations for the BoE, and a failure by Christine Lagarde to completely dissuade listeners of an ECB rate hike next year, by the end of the week most government bond markets had experienced sizeable moves. As a result, the two-year Gilt yield has now added 30bp over the last month, two-year USTs are over 20bp higher, BTPs 30bp higher and Bunds 10bp higher.
As mentioned, the BoE probably takes centre stage this week with the Thursday rate decision being very much live; 21 out of the 45 estimates in the Bloomberg survey expect an increase from 10bp to 25bp. However, the median estimate remains unchanged. Gilt yields indicate traders are certainly expecting the BoE to be active over the next 12 months – the January 2023 maturity is bid at 55bp and the January 2024 is at almost 75bp. The sterling swaps market observed even more volatility, with the one-year at 90bp and the two-year at 1.24%; technical factors influence this volatility and probably reflect the vast amount of hedging taking place as banks brace for yields moving higher. UK banks have also pulled a swathe of mortgage products and hiked mortgage rates in anticipation of a move by the BoE. Finally, looking at Bloomberg’s World Interest Rate Probability (WIRP) measure, the implied base rate in the UK is 1.17% by September next year, indicating an aggressive rate hiking cycle. Still, we should note the technical factors of the swaps markets do bear an influence on the implied base rate.
While the BoE has indicated its willingness to act in response to rising inflation, its decision making remains data dependent and the other factors at play in the UK economy, such as supply chain issues and problems with the infrastructure system due to a lack of HGV drivers, will not be ignored, even if the BoE cannot directly influence these issues. There is no doubt the UK has already experienced a tightening of financing conditions and, while the BoE might well hike this year, the speed of hiking suggested by the moves last week does seem overly aggressive. Nevertheless, it could present a more interesting short term entry point for investors looking to add risk-free assets. While in our opinion it remains a close call whether the BoE will hike or not, even if it does move on Thursday, a ‘dovish hike’ with higher rates accompanied by calming language remains a more likely outcome. If the BoE added hawkish fuel to the already aggressive moves witnessed recently, it would be a big surprise.
Whatever the outcome this week, central banks certainly have a tough job on their hands. The path to higher rates is likely to lead to further volatility, and central banks will have to tread very carefully to avoid the dreaded Policy Error headlines.