Rates Spark: Inflation Takes Precedence

Markets are putting more weight on inflation than on the risk it poses to growth. Heading into crucial Bank of England and Fed meetings, this means more hawkish pricing. Long-term inflation swaps are on the rise too, but market functioning remains impaired despite improving risk indicators.

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The reappraisal of central bank reaction functions since last week

Investors’ increasing discomfort with bonds can be traced back to last week’s European Central Bank meeting. In refraining from slowing down its normalization schedule, the ECB was understood by markets as signaling that the jump in inflation takes precedence over the hit to growth caused by the energy shock, rightly or wrongly. Given their higher headline inflation and frothier wage dynamics, it isn’t surprising that markets expect the BoE and Fed to have even less qualm about tightening.

Central bank tightening expectations are back at their most hawkish

Source: Refinitiv, ING

As a result, rates hike discount across OIS curves is on the rise again, bolstered by hopes that no further escalation will occur in the crisis that oppose Russia and the West. In many places, this means the path implied for central bank rates are at or near their previous peaks. This is a remarkable reversal of fortune that leave little room for any accident on the geopolitical front. In the near-term, further overshoot is likely, as the sell-off snowballs in illiquid markets, and as investors reduce their exposure further. In the long-term, we think the adjustment higher in rates is closer to its end than to its beginning.

Rising inflation expectations mean more upside to nominal rates

Source: Refinitiv, ING

Higher inflation expectations but market functioning remains impaired

The bond sell-off also coincided with a renewed push higher in inflation expectations. At face value, this seems contradictory to more hawkish central bank expectations, and to the recent decline in traded energy futures. In practice, the market’s more upbeat take on the war in Ukraine, and its ramifications for energy policy and supply chains, has revived the debate about long-term inflation dynamics. The risk of further disruptions due to rising Covid-19 cases in China and elsewhere is also bringing that debate to the fore.

Markets continue to expect impaired trading conditions

Source: Refinitiv, ING

 

Market functioning and liquidity remain key concerns. It seems that thinning volumes are magnifying volatility, which in turn is side-lining some market participants. Implied volatility is another indicator of how investors see the near-term prospect for market conditions. By that metric, caution remains prevalent, despite the jump in outright interest rates and stabilisation in risk markets. This makes progress towards balance sheet reduction, including outright bond sales by the Fed and BoE, another reason to tread prudently.

Today’s events and market view

Germany’s Zew survey is expected to show a sharp decline in its current and forward-looking components. This is no surprise given the onset of the Ukraine invasion and its economic fallout. It is too early in the month to pass a definitive judgement on sentiment in March but this release will help guide expectations. It is also likely that the most recent improvement in sentiment, and possible worsening of supply chain issues after the rise in Covid-19 cases in China, will impact the release less.

This week's government bond slate starts with 2Y Germany, and 10Y Finland auctions, alongside UK inflation linked debt.

In the afternoon, February PPI will be a reminder that inflation pressure remains elevated, while the Empire manufacturing survey will give investors a first glimpse of US sentiment in March.

ECB President Lagarde is also due to spark. Market pricing has moved resolutely more hawkish since last week’s press conference. Caution should be on display as the impact of the invasion of Ukraine is still being worked out.