Fixed Income Markets Don’t Like Hawkish Monetary Policy Surprises

Posted by lplresearch

Tuesday, November 2, 2021

When Turkey cut interest rates last month, it was the 1000th interest rate cut since Lehman Brothers collapsed in 2008, according to analysis by Bank of America. Moreover, since then, central banks globally have bought over $23 trillion of assets to help support financial markets. Now, with many major developed economies recovering from the COVID-19 shutdowns and inflationary pressures remaining stubbornly high, central bankers are likely going to start to reduce monetary accommodation over the next few years. As central bankers start to reverse course though, markets are aggressively reacting to hawkish surprises that are seen coming out of central banks.

“Interest rate volatility has definitely picked up,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “When fixed income markets are surprised by hawkish central banks, we’re seeing price action in some interest rate markets that is akin to equity markets–not developed sovereign interest rate markets.”

As seen in the LPL Research Chart of the Day, yields on 2-year Australian (orange line) and Canadian government bonds (light blue line) spiked higher last week when central banks in those countries turned surprisingly hawkish. For Canada, the Bank of Canada abruptly ended its bond purchasing programs and said interest rates would likely need to rise earlier in 2022 than markets were expecting. For Australia, the Reserve Bank of Australia (RBA) failed to defend its yield target, which is part of the RBA’s targeted program to keep interest rates low and is set at 0.1%. That the RBA allowed yields to move dramatically higher was seen as a sign that tighter monetary policy was coming. Those actions (or inactions as was the case by the RBA) surprised markets and bonds sold off dramatically.

View enlarged chart.

Now, the Federal Reserve (Fed) is on the clock. At this week’s Federal Open Market Committee (FOMC) meeting, the Committee is expected to announce plans to begin to reduce its bond purchase programs beginning this month or mid-December. Markets are expecting the Fed to announce a $10 billion a month reduction in Treasury security purchases and a $5 billion a month reduction in mortgage security purchases. The full tapering process is expected to last eight months after which, we think, the Fed will pause before interest rate hikes are considered. Meaningful deviations from that message may negatively impact markets like we’ve seen elsewhere. As the chart above shows, yields on 2-year U.S. Treasury securities (blue line) have inched higher over the past month but have not seen the type of move that was seen in other markets. We attribute that to the deliberate communication strategy by the Fed seemingly telegraphing its intentions months in advance. The last time the Fed was in this position (2013), though, markets were surprised by its hawkish shift. We think the Fed learned its lesson from that episode but a surprisingly hawkish statement by the Fed on Wednesday could result in a dramatic selloff in U.S. Treasury securities as well.


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