Tommy Wilkes and Yoruk Bahceli

LONDON (Reuters] – This week’s dramatic selloff of government bond markets makes it clear that central banks will panic about rising inflation and raise interest rates, thereby reducing economic growth.

However, stocks and corporate bonds send a completely different message. Perhaps you should buy even more.

Only time will reveal who’s right. What’s for sure is many bond investors were caught out by fears that central banks, despite their inflation-is-transitory mantra, may end up tightening policy sooner than signalled.

The short-term debt yields were fueled by a timid message from Europe’s Central Bank, Canada’s Reserve Bank of Australia and Canada’s cautious one. The bill yields in Australia saw their largest three-day increase since 1996, while those in the United States and Germany soared to their highest levels since March.

(GRAPHIC: bonds – https://fingfx.thomsonreuters.com/gfx/mkt/lbvgnoalopq/Aussie%20bonds.JPG)

Normally, these moves would result in significant disruption of asset classes.

They have not registered with the equity index reaching a new record on Thursday. Stocks fell Friday but losses are not severe. Lipper data indicates that investors bought equities in the week up to Wednesday at the fastest rate since March.

The volatility of equity and currency remains subdued. Wall Street’s Fear Gauge, the, is just below 2021 levels. Europe’s rates volatility is on the rise, but stocks are stable.

(GRAPHIC: European vol – https://fingfx.thomsonreuters.com/gfx/mkt/xmvjolmwnpr/European%20vol.JPG(

One explanation is that the sanguine reaction was due to relative calm in bonds with longer maturities. Yields indicate confidence that rapid central bank intervention will be swift enough to quell inflationary pressures, but not to disrupt economic momentum.

The “real” yields on bonds, which are adjusted for inflation and remain very negative, despite an increase Friday, they still hover around -1% in the United States, and -2% respectively in Germany.

Charles Diebel, Head of Fixed Income at Mediolanum International Fonds said, “It’s remarkable that stocks haven’t responded more but real yields such negative, markets aren’t too worried.”

“If you break down the forward curve of inflation, it is about the immediate pressure on inflation… Breakevens are moving higher but central banks have begun to respond which means that inflation activity will be slower and not a concern in the long-term.”

Market gauges of inflation expectancy often use breakevens to indicate the difference between inflation-linked and nominal bond yields.

Riskier corporate debt markets are not spooked. They pay historically low risk premiums on top of government bonds.

Barnaby Martin from BofA London, who is head of credit strategy said that “low real rates” has an impact on the markets.

TYPICAL MID CYCLE

Partly, the positioning is responsible for short-dated bond moves. Positioning was also a factor. Traders who were caught by the rise in yields had to exit their positions. This exacerbated the selloff, and some prices looked a bit farfetched.

Traders believe that the United Kingdom will raise its interest rate by over 100 basis points in the coming 12 months. Even the very dovish European Central Bank can be seen increasing interest rates twice before October 2022.

(GRAPHIC: Global money markets raise central bank rate hike bets Global money markets raise central bank rate hike bets – https://graphics.reuters.com/GLOBAL-MARKETS/klvykzkylvg/chart.png)

Chris Iggo, AXA Investment Managers, expects that higher rates will tighten financial circumstances a bit but stated it would be similar to “normalisation” in that we are going back to pre-COVID levels.

    “It’s typical mid-cycle type of economic conditions, where inflation has gone up a bit, rates have gone up, growth starts to slow, but it’s not a recession yet.”

Many remain optimistic that the central banks will not be affected by serious concerns regarding growth.

Martin of BofA explained that “the real widening in stocks (and corporate spreads), would occur on a recess, and not so much rate risk. Just because we have seen repeatedly over and over again that central banks will push back dovishly again if markets become troubled because of concern about interest rate risks,” Martin said.

Bond repricing is expected to eventually reach a wider audience, so some pain will be inevitable.

Citi strategist Matt King stated to clients, “Expect tantrums of risk if central banking responds inflation – or tantrums on bonds if it doesn’t.”