The degree and speed of monetary policy tightening in developed markets triggered renewed selling of equities and a further sharp rise in bond yields this week. An abrupt rise in financing costs, driven by the US bond market, is surging through global financial markets with considerable fallout already as a new paradigm is established.
That relentless series of rate hikes by the principal central banks in recent weeks, unprecedented in their pace, has been consistently accompanied by hawkish rhetoric. Policymakers have taken every opportunity to hammer home the message that getting inflation back under control is the primary objective, even if that means triggering a recession.
In Europe, higher energy prices are simultaneously raising inflation and weakening real demand. Nonetheless, European Central Bank President Christine Lagarde, echoed the sort of message sent by other developed market central bankers:
“We will not let this phase of high inflation feed into economic behaviour and create a lasting inflation problem. Our monetary policy will be set with one goal in mind: to deliver on our price stability mandate.”
Policy angst grips markets
The prospect of central bank monetary policy, and in particular the US Federal Reserve’s, on auto-pilot at a fast pace has unnerved financial markets. The last week has seen the most severe bout of turbulence in markets since the coronavirus crisis.
Bond yields in developed markets have shot up, while equities have sunk to new lows for the year. The extent of price movements has side-lined many investors who prefer to ride out the storm. Consequently, liquidity in the US Treasury market has deteriorated, worsening volatility (see Exhibit 1 below).
The magnitude of moves in global bond and currency markets is creating angst among investors about the risk of policy errors with monetary tightening going too far too fast.
Senior members of the Fed have been unambiguous in insisting that policy rates need to rise to a level that actively constrains the US economy and then stay there for an extended period. As a result, the risk of a global recession is perceived to have risen markedly, weighing on sentiment.
The fallout (so far)
Over the last week, financial markets have been through a series of events showing that policymakers outside the US are ignoring the consequences of the sea change underway in US monetary policy at their peril.
Last week, the Bank of Japan was forced to intervene in foreign exchange markets to defend the yen after the currency rapidly tumbled to a 24-year low against the US dollar.
Subsequently, plans for big tax cuts by the new UK government ignited a major sell-off in the UK’s currency and sovereign debt markets. Sterling this week hit an all-time low versus the US dollar at 1.035, while 30-year UK government bond yields climbed precipitously to make a 20-year high above 5%.
The turmoil was such that on 28 September, the Bank of England took emergency action, announcing a GBP 65 billion bond-buying programme aimed at restoring stability to UK government debt markets.
The central bank warned of a ‘material risk to UK financial stability’ from the turmoil and suspended its quantitative tightening programme of selling UK government bonds — part of measures to regain control over inflation — instead pledging to buy long-dated UK bonds at a rate of GBP 5 billion a day for the next fortnight.
These events have only served to further fuel the rise in US bond yields that accelerated after the Fed last week delivered its third-straight 0.75 percentage point rate rise and signalled significantly tighter monetary policy to come.
For the first time since 2010, the 10-year US Treasury bond yield reached 4% this week after ending August at 3.2 % (see Exhibit 2 below). This would constitute the biggest monthly rise since 2003. Having begun 2022 at around 1.5 % it is also set for its largest ever annual rise.
What happens next?
The extent and rapidity of rises in interest rates suggest that markets may have overshot. Investors will, however, remain cautious on the basis that the abrupt rise in financing costs may trigger further consequences as it filters through the financial system.
Our multi-asset portfolio management team have taken advantage of the rise in US bond yields to close their underweight position in US bonds. After a move of this magnitude in developed bond markets, the inclination is to cautiously establish overweight positions.