The Great Tug of War Between Investors and Central Banks

In recent weeks, inflation expectations have been quite polarized between investors and central banks. Whether this will remain the case is up in the air, however there are some indications that some central banks are getting the message.

While global central bank policy remains focused on the jobs recovery, inflation expectations continue to concern bond investors. The Federal Reserve, for example, professes no rate hikes until 2024. Conversely, the spread between the 1 and 3 year outlook for short-rates is pushing 120 basis points according to Eurodollar futures. Taken together, this indicates cognitive dissonance between central banks and markets. Central banks do not expect the economic rebound to get out-of-hand and cause inflation, yet market pricing has begun to reflect the opposite expectation.

Investors are suddenly pricing in at least a full hike over the next three years for the Fed, BOE, and RBA. ECB remains the easiest of easy central banks.

Additionally, volatility expectations for 2-year rates into 2023 have shot higher above pre-pandemic levels. In other words, investors have become increasingly antsy over the path of short-end rates in response to a heating economy and strengthening labor market.

Investors may very well be following the playbook written by global recoveries since 1960. The chart below shows the average path of U.S. 3-month yields into and after 50% of economies produced above trend leading economic indicators. Nearly all global recoveries began to see short-end rates appreciably climb from this point in the cycle. So who will win in this tug of war between investors or central banks?

The next chart compares global central bankers’ interest in inflation, derived by the content of their speeches, with the average 10-year global inflation breakeven across developed economies.

Central banks have definitely been speaking more about inflation in the past couple of months, but it is not apparent whether they are just trailing markets, or if it indicates an increasing concern by central banks. 

As a counter-argument to the latter, the below chart shows the rate of central bank speeches spent on financial stability. Interest clearly remains low, suggesting that the inflation measurement may be a bit of a false positive. Lofty valuations and tight credit spreads are not dissuading officials from maintaining easy policy.

 

The final point of interest is the level of passivity in central bank speeches. The Federal Reserve has been extraordinarily passive in its speeches over the past several months, staggeringly more so than the rest of the globe. Combined with AIT, this suggests the Fed is, if nothing else, consistent.  The following chart plots a rolling one-year average proportion of passive words in central bank speeches. The Fed is compared to an aggregate of the 50 other central banks we monitor.

If you are expecting the Federal Reserve to blink first, think again!

 

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