Major global equity indices sold off last week, as 10-year bond yields rose. There were several reasons for the sell-off in longer-dated benchmark bonds, but the trigger appears to have been the Bank of Japan’s decision on July 28 to move away from yield curve control, or capping the 10-year Japanese government bond yield at just 0.5 per cent.
This was seen by investors as a first step towards tighter monetary policy at the only major central bank that has yet to move away from ultra-loose monetary policy implemented during the pandemic.
While the BoJ did intervene last week to stem the rise in bond yields, Japan’s 10-year bond yield – at 0.64 per cent – is now at levels last seen in 2014.
The US 10-year yield rose after the BoJ policy tweak, but was largely unaffected by the decision from ratings agency Fitch to downgrade the US’s long term sovereign debt rating last week. Arguably, treasuries are seen as a “safe haven” regardless of their rating. However, the announcement of an increase in treasury issuance for the next quarter did help push up bond yields.
While all these events likely contributed to higher long-term borrowing costs, the main driver has been a repricing of recession risks to reflect a “soft landing” scenario, and thus tighter for longer monetary policy.
The International Monetary Fund recently upgraded its global growth forecast for 2023 to 3 per cent from 2.8 per cent previously after first-quarter growth came in better than expected. Labour markets in developed economies have been surprisingly resilient, as has consumer spending, even as interest rates have risen sharply and inflation has eroded purchasing power.
While there are signs that the US labour market may be cooling – fewer than 200,000 jobs were added in both June and July – the unemployment rate remains near record lows at 3.5 per cent and wage growth remains robust.
The anticipated recession in the US in the second half of this year now looks unlikely to materialise. Consequently, the path to lower inflation is likely to be slower and, as a result, interest rates are likely to remain high for longer.
At the beginning of the summer, the market was pricing a rate cut by the Fed by the end of this year and another in January 2024. The first expected rate cut has now been pushed out to the end of Q1 2024, and some analysts think the Fed will hold the line until the second half of next year.
Similarly, after the Bank of England’s decision to raise rates by 25bp last week, Governor Andrew Bailey indicated that monetary policy will need to remain “sufficiently restrictive for sufficiently long” to bring inflation back to the 2 per cent target, even as the Bank expects economic growth will be near flat both in 2024 and 2025.
While expectations for interest rate policy are reflected at the shorter end of the yield curve, higher 10-year rates reflect optimism that growth will be stronger than had been expected. The spread between 2-year and 10-year US bond yields is still negative, implying a recession over the next year, but the implied probability of a recession is much lower than it was just a month ago.
Khatija Haque is chief economist and head of research at Emirates NBD