Unraveling Rate Dynamics: Assessing Potential Upside and Central Bank Reactions
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Rates Spark: Where rates upside could come from
Yield curves are already consistent with the new hawkish message from central banks, so any rise in yields is more likely to come from economic data. Yields may well continue rising, to 4% for 10Y Treasuries, but this pis set to come with a more inverted curve.
Data is already in the price, as is the new more hawkish central bank reaction function
At the fundamental level, rates are currently driven by two forces. Firstly what the market’s current economic projections suggest is the appropriate path for policy rates in the future to bring inflation to target, and second what central banks suggest this path should be. Most of the time, these two estimates are very close to each other. It is worth remembering that in a “data dependent” setting where central banks are reacting to incoming data, efficient markets should quickly reprice with each important economic release, that is if central banks’ reaction function is clearly communicated and understood.
Market interest rates over the past few weeks have been driven by a reassessment in central banks’ reaction function
This point of the above reminder is to highlight that the retracement higher in market interest rates over the past few weeks has been driven mostly by a reassessment in central banks’ reaction function, especially in a context where the global outlook, for instance China's recovery, is dimming.
Cases in point are the resumption of the Bank of Canada’s hiking cycle, or the Fed’s skipping the June meeting but communicating that more hikes are likely. From here, the question is whether the much-awaited Powelltestimony tomorrow will deliver a further update to the Fed’s reaction function, or if markets materially differ from what the Fed sees as the appropriate path for policy rates.
Dollar and euro swap forwards are no longer pricing cuts before early 2024
