Analysis-Flexible inflation targets a recipe for bond market turbulence
9:54 am Wednesday, November 10th, 2021
By Dhara Ranasinghe and Sujata Rao
LONDON (Reuters) -For markets trying to navigate the pathway for stickier-than-expected inflation, a move to asymmetric price targets at the world’s two biggest central banks may be a recipe for wild and increasingly frequent bond price swings.
The U.S. Federal Reserve adopted in 2020 a flexible average inflation target (FAIT) designed to be more forgiving of price pressures than before, a major shift in the Fed’s dual approach towards achieving maximum employment and stable prices.
The European Central Bank followed this year, setting a 2% medium-term inflation target and ditching its long-established “below but close to 2%” goal.
Although both dismiss current price pressures as “transitory”, they are facing the first real test of these new frameworks.
“Hindsight is a beautiful thing, but it is unfortunate timing that we had those reviews,” said Rabobank senior rates strategist Lyn Graham-Taylor. “Under the old mandates, we knew the reaction function of central banks. Now there’s more uncertainty around that.”
Flexible inflation mandates make it harder to judge just how hot inflation will be allowed to run and whether central banks are at risk of moving too late.
Euro area annual inflation is above 4%, while the U.S. consumer price index exceeded 6% last month, stoked by supply bottlenecks and red-hot commodity prices.
While central banks cannot control such factors, they often act early to ensure consumers’ expectations of future inflation do not translate into significantly higher wages.
So New Zealand and Norway have started lifting rates; Britain and Canada are preparing to do so. While the Fed is set to unwind its $120 billion monthly stimulus, it shows no inclination to raise rates.
At the ECB, a move may not come for years.
But markets are wary of hawkish surprises.
For David Arnaud, a senior fund manager at Canada Life Asset Management, the asymmetric targets raise more questions than they address about central banks’ policy response.
“They’re saying we’re going to make up for past low inflation by allowing inflation to run hotter above 2%, so on average we’re going to be able to meet our 2% target,” he said.
“But for how long do you let inflation run above your target? What’s an acceptable level? These metrics have not been defined intentionally, because they want to keep their options open, but this has created uncertainty and makes the reaction function much harder to read for bond investors.”
Sovereign bonds are among the tools central banks deploy to transmit policy messages. But if investors don’t understand that message, confusion can ensue.
That’s what happened last month when bond yields shot up in anticipation that central banks would act against inflation, only to plummet as policymakers quashed those bets.
Italian 10-year yields swung from an 18 basis-point weekly jump to a 25 bps weekly fall, and even staid Germany saw 10-year borrowing costs drop 19 basis points last week, the biggest fall since 2012, a week after hitting 2-1/2-year highs.
The turmoil was caused by what was seen as a timid ECB pushback against rate-hike wagers. Policymakers have since calmed markets but positions for a 2022 move have not dissipated.
If the ECB does raise rates next year, it would violate its guidance or mean that inflation has busted all forecasts, BofA analysts note.
Recent swings were partly down to a positioning shakeout, triggered after Australia failed to defend a key target for bond yields and instead allowed them to soar.
This year’s steady rise in bond volatility to 20-month highs contrasts with the calm in forex and equity markets.
Salman Ahmed, global head of macro at Fidelity International, reckons the Fed has deliberately not defined FAIT parameters so it has the option to act if inflation stays high.
“This leads to a growth-inflation tango, which the bond market is switching back and forth from,” he added.
The outlook hinges on what trajectory inflation takes.
Vaccines and easing curbs on travel are already boosting demand for services over consumer goods, Purchasing Managers’ Index surveys show. Eventually that should ease supply chain stresses.
A services boom is more likely to cause wage pressures which policymakers will find harder to ignore, notes Paul O’Connor, head of multi-asset at Janus Henderson. Equity investors, with gains underpinned by central bank largesse, will be watching.
“We may see more turbulence in fixed income markets as they struggle to price what the policy response might be to labour market inflation,” he said, describing recent volatility spikes as “recognition that the ‘central bank put’ is diminishing.”
(Reporting by Dhara Ranasinghe and Sujata Rao; Editing by Catherine Evans)