Bond markets appear to be digesting Federal Reserve Chairman Jerome Powell’s hints regarding the potential that, notwithstanding the war in Eastern Europe, the US Federal Reserve may hike interest rates at a faster-than-expected rate in the future meetings. The Fed hiked interest rates by 0.25 percent for the first time since 2018, and Powell made it apparent that policymakers would be more determined to keep inflation under control, given the surge in global commodity prices fueled by the conflict between Russia and Ukraine.
At future meetings of the Fed’s Open Market Committee, the governor also hinted at the prospect of raising the interest rate at a greater rate, of 0.5 percent (FOMC).
On Monday, the yield curve in the US bond market was flipped for the first time since 2006, showing the difference between the long-term 30-year bond yield, which fell to 2.59 percent, and the 5-year bond yield, which jumped to 2.62 percent.
The yield curve depicts the difference between the yields offered by short-term bonds and those offered by long-term bonds, as indicated. The yield curve (graph) depicts the yield as a function of the bond’s maturity date. The recent reversal between 30-year and 5-year yields may herald a coming recession, as the gap between two-year and 10-year bond yields is typically a harbinger of a coming recession.
On normal days, the long-term return to investors is bigger than the short-term return, so the curve tends to trend upwards. However, the curve’s curvature indicates that investors believe the Fed’s decision to reduce expansionary policies by raising interest rates will suffocate the economy, resulting in a continuing decline in growth. That is, investors do not give the potential that the Fed will be able to reduce inflation and avoid the downturn, forcing it to lower interest rates again later a strong probability.
“The bond market has expressed a worsening of Fed members’ tone over the past week, with a high probability of raising 50 points in May, pricing 125 points in the next three decisions, meaning the market expects two moves of at least 50 points and a cumulative increase of about 200 points in the six decisions by the end of the year,” said Rafi Gozlan, IBI’s chief economist.
“The market’s estimate of the level of interest rates at which the upward trend will halt has also risen, to around 3% in the first half of 2023, while expectations of an interest rate drop later this year have remained steady.
“The likelihood that the Fed will be able to control inflation without causing a substantial slowdown or recession is low, and the bond market is progressively reflecting this as the yield curve flattens. In addition, the spread between two-year and 10-year bonds in the United States has decreased dramatically, with the difference being only approximately 10 basis points (PS).
“While this trend isn’t a guarantee of a recession, it does raise the chances of one in the next one to two years,” says the report. Gozlan continued.
Inflation may be slowed by rising energy prices.
Economists at Bank Hapoalim explain why “Inflation has already passed the point where central banks must weigh the impact on economic activity against the necessity to keep inflation under control. Inflation figures in the United States, and most likely also in Europe, may rise to double digits in the coming months as a result of rising energy prices.
“The dread of stagnation is growing, despite the fact that economic data does not show a definite decline and labor demand is high. Because negative interest rates make it difficult to combat inflation.”
Inflation in the United States hit 7.9% in February, resulting in a negative real interest rate of more than 7%. The question of when this process will come to a halt remains unanswered. The Fed members themselves predict that the interest rate will climb to 2.8 percent, but that a rate of 2.4 percent will suffice in the long run “”It’s only just,” the workers continued.
“After a decade of low interest rates, most of which were zero for ten years and did not reach one percent in the United States,” the bank says, “it is a little difficult for us to foresee a return to positive real interest rates.”
One of the causes for the flat yield curve in the United States could be this.”
Despite the fact that Israel’s inflation rate was 3.5 percent in February, compared to 7.9 percent in the United States, government bond yields climbed. The 10-year yield hit 2.39 percent this morning, the highest level since 2014, and the yield on the Israeli government’s two-year bond increased to 1.46 percent.
Inflationary pressures are also placing pressure on the Bank of Israel.
There is mounting pressure on Israel’s central bank to raise interest rates, albeit more modestly than in the United States.
The bank suggested an impending hike in interest rates during the “coming months” as part of its interest rate decision in February, as well as a modest and steady rate increase later on. However, since then, the inflation climate has shifted, with February’s reading of 3.5 percent startling for the second month in a row, above the upper limit of the Bank of Israel’s goal range (3 percent ).
Although much of the recent increase represents a supply shock caused by the high spike in commodity prices, which is projected to hamper growth, the deep negative zone in which the real interest rate is out of step with the economy is expected to rise in April. “An interest rate of 1% to 0.75 percent is likely to be expected in the second part of the year,” Gozlan added.
“The rise in general inflation and inflation expectations is projected to contribute to the start of the interest rate hike process in April, but the pace subsequently will be determined by the development of basic inflation, which has so far moved in a more moderate direction.
Because of the steep rise in commodity prices, inflation expectations have risen sharply in recent weeks. “The currency rate risk premium is still excessively large in the medium and long term,” Gozlan remarked.