Mike Dolan

LONDON (Reuters – Are policymakers and bond market participants both out of sync?

Inflation expectations are rising and long-term “real” bond yields continue to fall below zero despite G7 central bank becoming more hawkish about withdrawing super-easy Pandemic settings, sending markets scrambling for higher interest rates.

This isn’t how it works and will confuse not only investors, but also central banks that depend on these expectations for key policy decisions.

It is unclear whether the bond market has a profound message or if it is just trying to interpret post-pandemic economics in a confused way.

Investors’ expectations about the future of growth and inflation should be tempered if central banks do indeed tighten sooner than they thought a few weeks ago.

It’s clear that the central banks are shifting gears. The rhetoric of the big central banks now paints a picture that still shows ‘transient inflation gains, but maintained for longer. They also play louder music about rising dangers it could get stuck up there.

While the Bank of Canada ended their bond buying program and flagged rate increases, Australia’s central banking suddenly stopped intervening to control borrowing rates.

The U.S. Federal Reserve will announce next week a tapering of their emergency bond-buying programme, and the Bank of England plans to trigger the interest rate.

This shifting sands has caused a drastic flattening benchmark yield curves that have seen long-term borrowing costs drop relative to the spiking short term yields.

It is commonly interpreted as an indicator of economic slowdown, credit crunch or recession.

However, inflation expectations have not been lowered in a proportionate manner. In fact, they rose.

While nominal borrowing rates for 30 years are stable or falling, the equivalent inflation-adjusted or real bond yields have fallen further below zero.

This could be attributed to market noise or skews due to the rapid unravelling of investor wrongfooting. Many investors doubted that policy rates would increase for three years, despite being guided by the same central banks earlier this year.

Nonetheless, the frenetic market repricing for money this month is plotting a UK rate hike next week. Canada will also see a move in its first quarter. The Fed could liftoff rates as soon next month as it tapers next month. And even a slight ECB adjustment may be possible as well. [IRPR]

BEYOND MACRO?

Inflation expectations rose by at least 0.2% in the G7 10 year horizons alone in October, despite the fact that central banks were not hawkish. Real yields also fell to their lowest level in over a decade in Canada and Japan.

All three countries’ ‘breakeven rates’ derived from inflation-protected bonds markets now exceed central bank targets. These levels are unprecedented in over a decade.

Euro zone 5-year/5 year forward inflation swaps were above the ECB’s 2% target for 5 years for the first times, while real German Bund yields for 10-year fell below -2.0% the first week.

Others see it as an’stagflation trade’ in technicolour, a bond market that prices another decade of economic stagnation followed by persistent inflation.

Inflation expectations are not being met by central banks. This is due to a structural change in which credit policies don’t have any impact.

Is this a guess, or a conviction in a new world?

Steve Major, HSBC’s chief fixed income researcher reckons that it’s the inflation expectations who seem to be “most out of tune” when there’s increasing tension between movements in nominal and real yields.

This issue is extremely important to central banks. Should they respond to what the inflation-linked markets are telling them – and raise policy rates now?,” Major wrote.

Or should they wait and take comfort in the long-term bond yields while they ride out any bottlenecks or distortions that may be caused by an once-in-a century global pandemic?

Charles Diebel is the fixed income chief at Mediolanum International Fonds. He believes that a flattening yield curve makes sense, but he suspects there are other anomalies.

“It is very early in the cycle to see curves flattening that way. What it does is show that consensus positioning is being diluted.”

Deutsche Bank George Saravelos (DE:), strategist, believes that the market frenzy in money and large-scale moves in short term rates markets over the past decades has created the type of trading stress that can lead to other problems.

He stated that “What’s happening right now goes beyond macro,” and was referring to clients.

“This is as close to a distressed marketplace as we can get.”

Are they real? This is something that bond markets might still struggle to comprehend. They won’t be the only ones trying to figure it out.

By Mike Dolan. Twitter: @reutersMikeD. Sujata Rao, Alexander Smith Editing.