Aegon Asset Management: Yield curves and Interest Rates – are they wrong?

Government bond markets have experienced material volatility year to date, with yields rising to reflect changes in expectation for policy rates globally. Central banks are raising interest rates in response to the continued high levels of inflation being experienced in many countries. At the time of writing the bond markets are already discounting increases in rates to levels not seen since before the financial crisis of 2008. In the UK in particular, bank rate is already at 1%. In the UK, the market is implying through the yield curve that bank rate will peak at around 2.25%, in the US around 3% and in Europe 1.5%. The implied curves are shown below.

Market Implied Rates


Source: Bloomberg

As inflation has risen over the past 12 months, expectations for monetary policy have followed. The same curves at the beginning of the year were not discounting such a profile; in a comparison of market expectations for policy rates by the end of 2023 as of today and at the start of the year we can see that repricing of curves has occurred everywhere, but most in the United States.

What investors will be looking at now is whether this repricing has overshot or has further to go. Some guidance on this may have come from the recent Monetary Policy Report from the Bank of England who make economic forecasts on the basis of market implied interest rates. According to their forecasts the market implied level of rates would lead to a year of negative UK GDP growth in 2023 and inflation to falling well below target in 3 years’ time. This would suggest that in their opinion the market level of implied rates will be too restrictive for the UK economy. The most recent economic data would appear to confirm this outlook. For example, GDP in the first quarter was disappointing showing that the economy contracted in March and was weaker for the quarter as whole than had been expected. Industrial and Manufacturing production contracted in both February and March. Business surveys are softening, retail sales are falling along with consumer confidence. More positively though, the labour market looks strong and the housing market remains firm.

In our view therefore there is room for market implied rates in the UK to fall, assuming that there are no further shocks regarding energy/oil prices, which remain a significant driver of inflation pressure.
The US FOMC in their March communication had a more optimistic outlook. The median committee forecast for inflation was a return to 2.3% by 2024 without causing a recession and the median estimation of peak level of rates is just below the market implied forecast at 2.75 %. The FOMC will be updating forecasts again in June so markets will get more guidance as to their thinking regarding the appropriate level of rates. The US economy remains fairly robust with a very strong labour market. Some signs of concern are creeping into business surveys but on balance it is probably still too early to oppose market implied rate levels especially given recent strong inflation data and the current guidance from the FOMC.

In Europe, the ECB have not started to raise interest rates and have provided little in guidance as to appropriate levels. Again, the economy remains robust with employment growing and fiscal policy supportive. The ECB are expected to start to tighten policy in the H2 2022 and in this early stage we would not expect to get much guidance from the ECB. Unless the economy begins to show significant signs of weakness we would question an opposition of current market levels.

By Sandra Holdsworth

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