By Jamie McGeever

ORLANDO FL (Reuters). – Both the U.S. and UK bond exchanges are sounding the alarm.

The Yield curves on both the markets and in China are becoming flattened dramatically. This indicates that traders see a greater risk from a central banking policy error, or a more bleak outlook for long-term economic growth.

Or you can do both.

This is due to the sharp fall in yields on the 30-year end of the curve. Trades are also predicting the Federal Reserve’s first interest rate rises to combat inflation.

Although policy rates remain at zero and will not rise significantly after liftoff, excessive tightening of supply shock-driven inflation to combat excess could still choke growth or tip countries towards recession.

It is a mistake no central banker wishes to repeat the mistakes made by the European Central Bank in 2011, when they raised interest rates. This exacerbated the debt crisis and led to a recession.

When the difference between shorter- and longer-dated borrowing costs narrows, yield curves become flattening. They invert when long-term yields drop below short-dated yields. Inversion and slowing down often occur in both these scenarios.

This is why Wednesday’s actions deserve a closer inspection.

The 10s/30s curve in the United States fell below 50 basis points, for the first time since March 2020’s outbreak of COVID-19.

In the second straight day, the 2s/30s curve fell 9 basis points. It is the worst two-day fall in over 10 years.

On Wednesday, however, the spread between UK 2s/30s and the UK 1s/30s narrowed by 15%, which was the largest single-day decrease since March 2020, as well as one of the greatest drops in a decade.

The curve 10s/30s has been compressed down to 23 basis points. This makes it the most flat since the volatile and dark days of the late 2008.

“REAL DAMAGE”

It is all set against a background of record-breaking inflation, and the financial markets moving ahead with the timing for rate increases. The rate markets expect that the BoE will move in December and the Fed, September 2022.

Flattening yields suggests that this market believes it is too risky.

Deutsche Bank (DE:) A survey of 600 market professionals in this month’s March revealed that the central bank’s policy mistakes are the number two risk to market stability. This is behind high bond yields and inflation as well as growth worries.

More people believe that the Fed’s mistake would be to keep policy too loose, which is interesting. The economic harm could look similar to that of a hawkish misstep, since high inflation would reduce consumer incomes and corporate profits, thus limiting growth.

The greater danger is to tighten too quickly or too heavily. That is why, the Fed could be inclined to permit inflation to run a bit faster now, in order to lessen the more dangerous risk of deflation if the next recession occurs.

Scott Kimball is co-head U.S. fixed income, BMO Global Asset Management.

The ‘DEPRESSING VIEW’

The minutes of Wednesday’s Fed September policy meeting were published. They showed that many participants believe economic conditions warrant keeping the Fed funds rate at or close to its lowest bound for the next two years. Many participants agreed that inflation will continue to fall in the coming years.

However, participants believe that the Fed will be able to raise rates in the coming year due to the favorable labor market conditions and high inflation. Some participants expect that inflation will remain high in 2022. There are also risks.

Is it the greater group or are there more FOMC members than one?

As the Deutsche Bank survey reveals, there is a clearer risk in Britain: the BoE may raise rates early.

Futures markets almost price in a rate increase of 15% in December, 25% in February and 50% in May.

The aggressive market expectations are not being met by banks officials. Their inaction has only contributed to the madness, and it would damage their credibility if they tried to rebut.

Pre-emptive rate rises are necessary to stabilize inflation expectations and limit the potential size of future increases.

Ross Walker, NatWest Markets’s weekend writer said that “choosing not to choke domestic demand to arithmetically compensate external cost pressures” is a sad prospect.

“If there is to be monetary policy error – premature and excessive rate rises – it will be in the UK.”