As central banks ease, why are long-term rates rising?

Policy rates down, long-term rates up

Since mid-September, a somewhat counterintuitive but notable shift has occurred in long-term rates: central bank announcements of reductions in short-term policy rates have been closely followed by increases in long rates. This market reaction is particularly surprising because every G10 central bank except Japan’s has now initiated its rate-cutting cycle. Even China has recently started a cycle of monetary stimulus. 

Initially, these central bank rate cuts seem more aligned with a ‘recalibration’ of monetary policy than a series of pre-emptive cuts ahead of a recession, and bond market behaviour can be interpreted as adjusting to this new monetary landscape. However, rising long-term rates suggest that the market's perception of monetary policy has shifted significantly. In this weekly instalment of Simply put, we aim to determine whether this scenario can persist. Our analysis begins by understanding the underlying factors.

A change in the markets' reaction function

Regardless of which G10 rate curve we consider, the conclusion remains consistent: from May to mid-September 2024, each meeting of the US Federal Reserve (Fed) or European Central Bank (ECB) led to a reduction in expected inflation. This is clearly depicted in Figure 1, which shows inflation expectations as measured by inflation breakevens in Germany, France and the US from March to October 2024¹. In the US, inflation breakevens decreased from 2.4% at the end of April to just under 2% at the beginning of September. Since the Fed’s long-run inflation target is 2%, this should represent the peak of its credibility. This trend is not limited to the US: as the chart shows, the path of French and German breakevens also supports the view that G10 central-banks dovishness during this period was perceived as disinflationary. 

FIG 1. German, US and French 10-year inflation breakevens, March to October 2024²

Nevertheless, any sense of triumph over inflation was short-lived. Following the ECB meeting on 12 September, market perceptions shifted. With rate cuts no longer seen as disinflationary but as inflationary, inflation expectations began to climb again across all curves. Some might speculate that the market’s behaviour was influenced ECB by President Christine Lagarde's speech, but it was probably driven more significantly by the US inflation report on 11 September. The data showed inflation had unexpectedly risen for the first time since May. This, coupled with the dovish stance of central banks, prompted the market to reassess the long-term inflation outlook in both the US and Europe. 

These inflation ‘surprises’ – which were largely anticipated by our inflation nowcasting signals – appear likely to persist, especially in the US. We should therefore remain vigilant about the combination of dovish central bank rhetoric and unexpectedly high inflation, which is a mix that could put pressure on bond markets in the near term. However, expected inflation is just one component of long-term rates. What about the other components?

What could pull rates down?

Long-term rates can be broken down into three components: expected inflation (as illustrated in Figure 1), real rates (i.e., observed market rates net of inflation), and the fiscal premium, which is measured by each country's credit default swap (CDS) rates. Recent trends in the composition of long-term rates for the same three countries are shown in Figure 2. As you can see, the substantial drop in yields between May and September can largely be attributed to a fall in the inflation component, which accounts for a significant portion of the robust performance observed in the bond market during the third quarter. 

FIG 2. Composition of 10-year interest rates for the US, Germany and France, May-October 2024²

However, we should consider the following points:

• Regarding inflation, if the recalibration of monetary policy was perceived as being so disinflationary, it was partly because in late July and early August market makers feared that monetary policy could in fact prove recessionary. With the latest growth data stronger than expected, the tide has clearly turned
   
• In terms of real interest rates, as we have discussed previously in this column, with global savings drying up and investment needs on the rise, it is difficult to see real rates falling further 
   
• For its part, the fiscal premium could rise somewhat in the future both in Europe and the US, given the significant fiscal consolidation necessary on both sides of the Atlantic. For the time being, however, there has been little change – even in France, where some of the current tensions are concentrated. 
   

Bearing in mind these factors, in the short-to-medium-term, a sharp decline in long-term rates may be unlikely. Instead, bear steepening could continue, particularly if the ECB and Fed persist in cutting rates despite current cyclical improvements. 

As things stand, the primary argument in favour of expecting a drop in long-term rates is the potential impact of fiscal consolidation in 2025. Should this long-anticipated action be fully implemented, the procyclical effect could lead to a significant reduction in the inflation premium, followed by a mechanical decrease in long-term rates. It should be noted, however, that we are currently a long way from this scenario and budgetary deviations by governments have become commonplace. In the US, the theme of fiscal responsibility (or the lack of it) could dominate the post-election news cycle, posing a challenge for disapproving bond vigilantes who are currently struggling to assert their influence amid the noise from central banks.

What this means for All Roads

In terms of the implications for our strategy, our asset allocation has undergone significant revisions over the past two months, reflecting the gradual normalisation of bond volatility and the more positive trends observed in Q3. Currently, our allocation³ comprises a 60% exposure to hedging assets – covering duration, inflation, and volatility – and 40% in cyclical assets. This ratio aligns closely with our long-term strategic allocation. We would need to see a more pronounced upward trend for bonds than what our investment signals have so far indicated before considering a more defensive stance.

Simply put, for long-term bond yields to fall more sharply, an endogenous or exogenous cyclical downturn will be necessary.

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises are designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

• Recent economic data we have collected continues showing signs of a cyclical improvement in growth
• Inflation pressures are rising, with our US inflation signal in positive territory
• The improving macro backdrop is unlikely to shift the current dovish monetary policy consensus for now.
   

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).