As recession fears grow and several metal and agri commodity prices have come down, bond markets have priced out a significant amount of central bank rate tightening in recent weeks. The implicit assumption here is that an economic downturn will help central banks get the inflation genie back in the bottle.
With inflation yet to show a decisive turn lower, however, concerns that medium to longer-term inflationary expectations could become ‘unanchored’ from central bank inflation targets are unlikely to dissipate quickly. This could constrain central banks in coming to the rescue if recession were to hit soon.
The exception is China, where the central bank retains an easing bias – and inflation pressures and expectations remain contained. For the US, we expect the Fed to hike aggressively in July and September, in order to bring the fed funds rate back to a level seen as neutral. It remains to be seen whether the Fed will be able to take rates much beyond 3%.
Meanwhile, as the ECB is about to deliver its first hike in 11 years, the focus has shifted to a new anti-fragmentation tool, which should enable the central bank to proceed with rate hikes. We continue to second-guess the market discount that the ECB will sustainably raise the depo rate from -0.5% to above 1.75% in coming years.
For now the BoJ is seen as the largest DM outlier as it keeps monetary stimulus going by defending the yield curve control via bond purchases. But that is not without cost, given the strong depreciation of the yen and rising illiquidity risks in the JGB market. Both risks highlight that the BoJ cannot maintain yield curve control indefinitely and we expect changes to come in the next few months.
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