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Are we moving from doves to hawks in monetary policy?

Are we moving from doves to hawks in monetary policy?
Photo by Suzy Hazelwood from Pexels

From Frankfurt to Washington, Tokyo to Threadneedle Street, the cooing of doves grows softer.

In the halls of the world’s central banks, talk turns from so-called 'dovish' monetary policy, like lower interest rates and asset purchases, to something much less accommodating. Not a 'hawkish' programme of aggressive interest rate hikes, perhaps, but a stance far less supportive than stock and bond markets have grown accustomed to. 

In the UK, the Bank of England has finished buying gilts with newly created money and has raised interest rates for the first time since the pandemic. The European Central Bank will slow down, or taper, its bond buying, while the Bank of Japan has cut back already.

After a dalliance with calling inflation “transitory”, the US Federal Reserve has started tapering too, and has said that it expects to raise rates promptly after its bond buying ends, and to start running down its $8tn (£5.9tn) bond portfolio shortly after its rate hikes start.

What does this mean for markets? The honest but least satisfying answer is that we do not know. It depends on the real and perceived impact on inflation and growth. 

What is in a bond yield?

Bond yields reflect several kinds of expectations. Like expectations for inflation: if you expect high inflation, you will demand a higher yield to hold a bond.

Or expectations for short-term interest rates. If you reckon you will average 4 per cent a year in the bank for the next 10 years, a 10-year bond yielding 2 per cent has little appeal. And yields reflect expectations for economic growth.

Investors anticipating a boom gleefully ditch the safety of bonds for the exciting prospects of stocks. Those fearing a bust retreat to bonds as a haven from the ravages of stock market volatility.  

Expectations are the key because central bank actions famously work with a 'long and variable lag'. Markets react more quickly. Nine months ago, interest rates in the US were near zero. Today, they are still very much near zero, but investors’ expectations for interest rates have changed a great deal, flowing straight through to bonds.

Nine months ago, two-year US Treasuries yielded about 0.15 per cent. Today they yield close to 1 per cent. That would make no sense if the market expected 0 per cent interest rates to persist. But it makes perfect sense if the market expects rates to rise above 1 per cent over the next two years, as it now does. 

What do rising interest rates mean for markets?

Maybe central banks get what they want. They raise interest rates enough to calm inflation, but investors believe economies will continue to hum. With inflation tamed, bond yields do not need to rise much, and bonds do fine.

With bond yields low, equity valuations can remain high too. And with the economy churning along, corporate profits are fine, supporting good performance for both credit and equities. This is the goldilocks ideal.