William De Vijlder

Financial markets in the UK have recently been confronted with a ‘dash for cash’, whereby investors sell off even safe assets such as long-term government bonds to obtain cash. The catalyst was the announcement of an expansionary fiscal policy, which might force the Bank of England to hike interest rates more aggressively given the potential inflationary consequences. Leverage and the ensuing margin calls acted as an accelerator of the jump in Gilt yields. The events show the necessity for a coordination of economic policy. In case of elevated supply side inflation, this means monetary tightening to trigger disinflation, targeted fiscal policy support to those who suffer most from inflation and macroprudential policy that address the consequences from market volatility and large increases in bond yields.

A lasting, unwarranted widening of sovereign spreads in the euro area would represent an excessive tightening of financial conditions and weigh on activity and demand. It would run into conflict with the objectives of the ECB in the context of its monetary policy normalisation. Spreads are influenced by various fundamental variables that are directly or indirectly related to debt sustainability issues. These tend to be slow-moving. Sovereign spreads also depend on the level of risk aversion, a variable that fluctuates a lot and which is influenced by global factors. This complicates the assessment of whether an observed spread widening is warranted or not.

In recent weeks, the prospect of several ECB rate hikes has caused an increase in Bund yields and, unexpectedly, several sovereign spreads. Beyond a certain point, higher spreads may become unwarranted. Under such circumstances, the ECB might consider stepping in to avoid that its policy transmission would be impacted. Determining whether sovereign spreads have increased too much is a real challenge. Historically, based on a 20-week moving window, the relationship (beta) between the BTP-Bund spread and Bund yields fluctuates a lot, so this calls for taking a longer perspective. Using data since 2013, the current spread is in line with an estimate based on current Bund yields. Clearly, other economic variables should be added to the analysis. It shows the complexity of the task should the ECB commit to address unwarranted spread widening.

The war in Ukraine has caused a jump in commodity prices that will trigger a further increase in inflation and will weigh on GDP growth.  Unsurprisingly, the narrative that stagflation is in for a comeback is gaining ground, as shown by the increasing number of media references to this topic. Stagflation is a multi-year phenomenon of high inflation and a high rate of unemployment. Although inflation is high, the other conditions are clearly not met today. Monitoring financial markets developments is useful in gauging whether stagflation risk is on the rise. This can be done by comparing the developments in breakeven inflation and the high yield corporate bond spread. In the US, both have increased recently but it seems premature to interpret this as a sign that markets have already started to price an increase in stagflation risk. After all, these developments are of a very recent nature and the high yield spread is still low.

For the first time since May 2019, 10-year Bund yields have moved back in positive territory. Three factors explain this development. Firstly, the traditional international spillover effect of developments in the US Treasury market where following a more hawkish tone from the Federal Reserve, yields have been on a rising trend since early December 2021. Secondly, markets are pricing the end of PEPP and the tapering of net asset purchases by the ECB.  Finally, there is the prospect that, at some point, the ECB will raise its policy rate. Bond markets in the US and Germany have become highly correlated since 2021. This is an important factor given the imminent start of a rate hike cycle in the US and its possible influence on Treasury yields and, by extension, yields in the euro area.

Several factors might explain current market behaviour in the face of higher inflation. Firstly, the high inflation is considered transitory. This is the belief of the central banks and it is shared by professional forecasters, who are collectively predicting that inflation will fall next year. The findings of the European Central Bank’s survey of monetary analysts and the US Federal Reserve’s survey of market operators are both along the same lines.

Successful market timing between equities and cash requires high skill levels. Very low official interest rates, through their impact on market rates, create a disincentive for doing market timing because they increase the break-even skill level. The same applies for quantitative easing. These considerations are important from a financial stability perspective. Growing investor reluctance to do market timing will probably lead to a decline in equity market volatility and an increase in equity valuations. The former provides a false sense of safety whereas the latter increases the sensitivity to negative news and hence increases the riskiness. 

The significant decline of Treasury yields from their peak at the end of March is puzzling given the growth forecasts and the recent inflation data. This suggests that investors side with the Fed in thinking that inflation will decline. It also reflects the weakening of data in recent weeks, which implies that markets focus more on the change in the growth rate than on its level. The sensitivity of bond yields to economic data moves in cycles. One should expect that, as seen in the past, a less accommodative US monetary policy would increase this sensitivity because these data will shape expectations of more tightening or not. Before reaching that stage, we should already expect an increased sensitivity in the course of 2022, because it is quite likely that inflation will remain above the FOMC’s target.

The following issues are discussed in this interview : is it time for Fed members to update the interest rate dots? Would that put Jerome Powell under pressure explaining how monetary policy can stay ultra-loose until the US returns to full employment? What problems US monetary policy is causing in the euro area.

While the US economy is in a good position to cope with a certain rise in long rates, in the euro area higher bond yields under US influence could have untimely negative effects.

In recent months, US government bond yields increased significantly on the back of higher inflation expectations but more recently, higher real rates have been the key driver. The latter development is in turn related to the prospect of massive additional fiscal stimulus. Unsurprisingly, the dynamics in the Treasury market have had global spillover effects, raising concern about an unwanted tightening of financial conditions.

Until recently, the rise in long-term interest rates did not stop the equity market from moving higher, but events this week suggest investors are becoming increasingly concerned. The possible impact of higher bond yields on share prices, depends on what causes the increase: faster growth, a decline in uncertainty, rising inflation expectations.The last factor is the trickiest one because it may cause a profound reassessment of the outlook for monetary policy. Over the past two decades, the relationship between rising rates and the equity market has not been statistically significant. Gradualism in monetary policy has played a role. Recent statements by Jerome Powell show he is very much aware of the importance of avoiding to create surprises.

Academic research shows that certain investors look at single stock call options as lottery tickets. They are aware they can lose money but nurture the hope of very big gains. To some extent, the share price behaviour in recent days of certain US small cap stocks illustrates this thinking. The combination of herd-type momentum buying and a short squeeze has caused huge share price swings. Should this become a recurrent phenomenon, it might reduce the informational efficiency of equity prices, increase the required equity risk premium and influence the cost of capital of companies.

 In recent months, the dollar has weakened versus the euro although the real bond yield differential between US Treasuries and Bunds has increased. Amongst the factors that may explain this development, Federal Reserve policy is particularly important through its impact on capital outflows from the US and currency hedging behaviour of eurozone investors. The biggest risk for a change in direction of the dollar would be a repetition of the ‘taper tantrum’ of 2013 with the Federal Reserve starting to point towards a possible beginning of the normalisation of its policy. However, such a change in guidance is not to be expected anytime soon.

Yields on US Treasuries and German Bunds tend to be highly correlated but since the end of August, Bund yields have been essentially stable whereas treasury yields have increased.This spread widening is explained by a rising real rate differential, to a large degree due to a decline in German real yields. This could reflect a more gloomy view of bond investors about the growth outlook in Germany and, by extension, the Eurozone. Another, more likely, interpretation is that the real rate risk premium has declined in Germany due to the asset purchases of the ECB. In such case, investors will become increasingly nervous about the prospect that in a post-pandemic world the ECB will eventually have to stop the net purchases under its PEPP.

It is quite likely that, going forward, fighting recessions will be the remit of governments with central banks facilitating this task by creating cheap financing conditions. As a consequence, public indebtedness may very well remain high.One should wonder whether this could end up having negative consequences. A possible transmission channel is the pricing of government debt via a sovereign risk premium. Another factor can also play a role. Since 2015, when German bond yields increased, the rise in Italian yields has been even bigger -so the spread widens- whereas French yields have increased in line with German yields. These results suggests that, even in an environment of public sector securities purchases by the ECB, the high level of Italian debt influences the reaction to movements in Bund yields. Clearly, in the absence of QE, one would expect this effect to be at least as powerful.

In the US, the behaviour of the equity market versus the level of employment is very different in the current recession compared to previous recessions. The recession this year stands out because of its sudden, enormous job losses, which were quickly followed by a significant albeit very incomplete recovery. The equity market, after a huge drop, has rebounded swiftly and made new highs although earnings –on a 12 month moving average basis- still have to rebound. For 2021, more than anything, earnings growth matters.