Rising prices and hawkish central banks have pushed yields higher this year, leading to worries about a policy error causing a recession.
“Inflation has been front and centre on every investor’s mind and the war [in Ukraine] has only exacerbated the situation,” said Adam Ditkofsky, portfolio manager and vice-president at CIBC Asset Management, in an interview last week.
Commodity prices, particularly for energy and food, have soared. Coupled with easing Covid restrictions in the West and ongoing global supply chain disruptions, Ditkofsky said “it’s clear that elevated inflation is not going away anytime soon.”
Inflation has already caused bond yields to move sharply higher, as have expectations that central banks will raise interest rates quickly and reduce stimulus in order to get inflation under control.
In March, both the Fed and the Bank of Canada raised rates by 25 basis points and provided some guidance on future rate hikes. The Fed is now projecting six additional quarter-point rate hikes this year, compared to three projected in September.
“The underlying message from both central banks is that they will do what it takes to get inflation under control,” Ditkofsky said.
That could include raising rates faster or by more than 0.25%, or shrinking balance sheets quicker than the market is expecting.
A report this week from TD Bank noted the Fed last hiked this aggressively right before the global financial crisis, raising rates from 1% in mid-2004 to 5.25% in 2006 before the booming housing market collapsed.
“Still, rate hikes need not end in tears,” the report said, pointing to “soft landings” during tightening phases in 1965, 1984 and 1995.
TD cautioned, however, that “the faster the rate-hiking cycle, the lower the odds are that this is achieved” — and that the Fed is behind the curve.
Another important factor, Ditkofsky noted, is market expectations.
CIBC updated its rate forecasts earlier this week. In Canada, the bank’s economists expect the overnight target rate to hit 1.5% at the end of this year and 2.25% by December 2023.
It forecast the yield on Canada 10-year bonds — which have already shot up 1% this year to higher than 2.5% this week — to peak at 2.75% in March 2023 before declining.
CIBC forecast the Fed funds rate to be in the 1.5% to 1.75% range by the end of this year and between 2.25% and 2.5% at the end of 2023.
It forecast the yield on 10-year Treasuries to peak at 2.7% in June 2023.
“There are a lot of hikes already priced into the market,” Ditkofsky said. “The question we should be asking now is: Have we already seen the bulk of the move higher in interest rates?”
If history is a guide, he said, bond yields generally “see the bulk of their moves higher before central banks start to hike.”
In terms of the risk of a policy error, which happens when central banks hike rates too fast or reduce their balance sheet too quickly and cause a recession, Ditkofsky looks to the yield curve for guidance. All eight recessions over the last 50 years were predicted by the 10-year Treasury yield falling below the three-month yield, he said.
While this hasn’t happened yet, Ditkofsky said “there are definitely real risks of a policy error.” He pointed to other parts of the curve that have already inverted. This week, the yield curve for 10-year and two-year Treasuries — a more common recession gauge — briefly inverted.
When this happens, Ditkofsky said it puts both the bond market and economists on recession watch. Expectations are that the Fed will continue to hike rates as it tries to ease inflation, but Ditkofsky said the hope is that central banks will pause their rate hikes after several meetings to assess the implications of their actions and avoid unintended consequences.
“The Fed and the Bank of Canada definitely appear to be late to the game with hiking rates,” he said. “And there are definitely real risks of a policy error.”
In terms of implications for GDP, Ditkofsky said inflation has already had negative consequences. Inflation has outpaced wage growth, causing real wages to shrink. As a result, despite the U.S. being almost back at full employment, consumer buying power has fallen. In March, the Fed reduced its GDP forecast for 2022 to 2.8% from 4.1%.
Ditkofsky said CIBC also downgraded its 2022 growth outlook for both Canada and the U.S. from about 3% in December to closer to 2%.
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