How are bonds holding up as inflation seems to settle?

The rise in yields across global bond markets over the past three months brought home a reality that many had long suspected. Namely, that letting just enough air out of the world economy to reduce inflation without triggering recession is a difficult and drawn-out process.

Despite the sharpest interest rate rises in 40 years, core consumer prices remain high.

In the US and Europe the core measure is still close to twice the central banks’ 2 per cent target – in the UK it is more than three times. Central bankers may not raise rates much further, but they are still a long way from cutting them.

The ‘higher for longer’ mantra for rates has been repeated by the US Federal Reserve, the European Central Bank and the Bank of England over the past two months. The bond markets appear to be listening.

Ten-year US treasury yields climbed more than 0.9 per cent over the past three months to 4.8 per cent (the highest since 2007), while in the eurozone yields rose by about 0.4 per cent.

Even Japanese bond yields climbed, after the Bank of Japan further relaxed its yield curve control programme. Interestingly, one market that proved relatively defensive was UK gilts, where yields stayed at around 4.5 per cent, after a sharp sell-off earlier in the year.

Matterhorn or Table Mountain?

It is important to remember that a higher for longer strategy is not the norm for central banks. When rates peak, they talk of patient and gradual cuts, only to slash them aggressively once recession appears on the horizon.

Indeed, bond traders have an old adage that interest rates ‘take the stairs up and the elevator down’ – an observation borne out in almost every slowdown since the early 1970s.

This time, the world’s central bankers seem determined to hold rates near current levels, at least until the second half of 2024.

Huw Pill, chief economist at the BoE, recently described the traditional rate cycle as being like the Matterhorn: a long climb up and then a sharp descent. What we need today, he said, is something more like Table Mountain (he was speaking in Cape Town), where rates move up sharply but stay flat for a protracted time.

Fed chairman Jerome Powell delivered a similar message at the Jackson Hole conference in August, saying the Fed would “hold policy at restrictive levels until we are confident that inflation is moving sustainably down toward our objective”.

Beware premature victory celebrations

Such determined and unified policy statements are encouraging, because a recent study by the International Monetary Fund shows that central bankers generally ease too early.

After examining more than 100 inflation shocks in 50 countries, the authors concluded that in 60 per cent of cases it took at least five years for inflation to return to target.

The policy failures came, almost universally, from central bankers’ "premature celebration" of success.