Bond markets are apparently digesting the signals from Federal Reserve Chairman Jerome Powell about the possibility that despite the war in Eastern Europe, the US Federal Reserve will raise interest rates in the coming meetings at a higher-than-expected rate. About a week ago, the Fed raised interest rates by 0.25%, for the first time since 2018, and then Powell made it clear that decision-makers would be more determined to curb inflation, given the surge in world commodity prices encouraged by the war between Russia and Ukraine.
The governor also signaled the possibility of raising the interest rate at a higher rate, of 0.5%, at subsequent meetings of members of the Fed’s Open Market Committee (FOMC).
For the first time since 2006, the yield curve in the US bond market was reversed on Monday, representing the gap between the long-term 30-year bond yield, which fell to 2.59%, and that of the 5-year bond, which rose to 2.62. %.
The yield curve represents, as stated, the gap between the yields given to investors by short-term bonds, and those that are provided by long-term bonds. The curve (graph) shows the yield according to the maturity date of the bonds. Typically, the gap between the two-year bond yields and those of 10-year bonds is an indicator of a recession that is expected to come, and the current reversal between 30-year and 5-year yields may signal this.
On routine days, the return to investors in the long run is higher than the return in the short run, so the curve tends to climb upwards. But the curvature of the curve reflects a situation in which investors estimate that the Fed’s move to curb expansionary policies, by raising interest rates, could stifle the economy to the point of a continued slowdown in growth. That is, investors do not attribute a high chance to the possibility that the Fed will be able to moderate inflation and evade the slowdown, which will force it to lower interest rates again later.
“Over the past week the bond market has expressed a worsening of the tone of Fed members, 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.
“There was also an increase in the market’s assessment of the level of interest rates at which the upward trajectory will end, to about 3% in the first half of 2023, and expectations that an interest rate cut will be recorded later this year remain unchanged.
“The probability that the Fed will be able to moderate inflation without a significant slowdown or recession is not particularly high, and the bond market is gradually showing this as the curve continues to flatten. Also, the steepness between the two-year and 10-year bonds in the U.S. has dropped significantly, and the gap has narrowed to only about 10 basis points (PS).
“While this development is not a definite indication of a recession, it does increase the likelihood of it over the next one to two years. “, Gozlan added.
Energy prices may bounce inflation
Bank Hapoalim economists explain that “inflation has already crossed the threshold where central banks balance between hitting economic activity and the need to curb inflation. Energy prices may bounce inflation figures in the US, and probably also in Europe, to double-digit levels in the coming months.
“The fear of stagnation is rising, although so far the economic data do not indicate a clear slowdown, and demand for workers is high. Because it is difficult to eradicate inflation with negative interest rates. “
The US inflation rate reached 7.9% in February, so the real interest rate stands at a negative rate of more than 7%. The question of where this process will stop is still open. The Fed members themselves also believe that the interest rate will rise to 2.8%, but in the long run, an interest rate of 2.4% is more appropriate, “the workers added.
The bank adds that “after a decade of low interest rates, most of which the real interest rate for ten years was zero, and did not exceed 1% in the US, it is a little difficult for us to imagine a return to positive real interest rates. “This may be one of the reasons for the flat yield curve in the US.”
Although inflationary pressures in Israel are lower, as the inflation rate was 3.5% in February, compared to 7.9% in the US, government bond yields have also risen. In the domestic bond market, the 10-year yield reached 2.39% this morning, a record since 2014, and the yield on the Israeli government’s two-year bond rose to 1.46%.
The rise in inflation is also putting pressure on the Bank of Israel
In Israel, too, there is growing pressure on the central bank to raise interest rates, albeit moderately relative to that in the United States.
As part of the interest rate decision in February, the bank signaled an imminent increase in interest rates during the “coming months”, along with a slow and gradual rate of increase later on. However, since then there has been a step up in the inflation environment, surprising for the second month in a row with a level of 3.5% in February, thus exceeding the upper limit of the Bank of Israel’s target range (3%).
Although much of the recent rise reflects a shock to supply due to the sharp rise in commodity prices, which is expected to lead to a slowdown in growth, the deep negative territory in which the real interest rate is not in line with the economy is expected to rise in April. “July, and is likely to expect an interest rate of 1% -0.75% during the second half of the year,” Gozlan said.
“The rise in general inflation and inflation expectations are expected to lead to a start in the process of raising interest rates in April, but the pace later will be affected by the development of basic inflation, which has so far moved in the direction of a more moderate rate of increase.
Inflation expectations have risen sharply in recent weeks, due to the sharp rise in commodity prices. “The exchange rate risk premium inherent in the medium and long term continues to be too high,” Gozlan said.