Over the past three months, interest rate volatility has been significant. However, the steepening movement could nevertheless be seen as a positive signal, provided that central banks accelerate their pivots.
Since October 15th, everything has accelerated for interest rates. On that date, concerned about a potential resurgence of inflation and with no clear outlook for easing financial conditions by central banks, 10-year rates in the United States hovered around 5%, 10-year rates in France reached 3.5%, while the Bund approached 3%.
As of December 31, two central bank meetings later following Jerome Powell’s statements, a complete change of landscape: after a very rapid decline, new symbolic thresholds are crossed, this time on the downside. The T-Bond has dropped below 4%, and even below 3.9%, the Bund is at 1.9%, while the 10-year OAT now yields only 2.4%.
Since January 1st, the turmoil persists, but this time in an upward direction, and just as swiftly. In a little over two weeks, the 10-year reference rate has risen from 2.4% to 2.8% in France, from 1.9% to 2.3% in Germany, and from 3.8% to 4.15% in the United States. As a result, volatility in interest rates, measured by the MOVE index, remains high, even though it has eased somewhat since the beginning of the year. During the last two months of 2023, in relative terms, it proved to be higher than volatility in the stock markets (VIX index), which is very unusual.
Three lessons can be drawn from this phase of volatility:
1- The first lesson from this heightened volatility is that the growth scenario remains uncertain in 2024. While the end of 2023 had been marked by strong optimism regarding the resilience of global activity, the beginning of the new year is more characterized by uncertainty.
Quite logically, on one hand, U.S. consumption is admirably resilient, as demonstrated by December’s retail sales and the survey released on Friday, January 19, by the University of Michigan on consumer sentiment. On the other hand, on this same January 19, China announces its decision to cut funding for certain infrastructure investments through regional banks. Even though the soft landing scenario remains central, the clouds have not cleared, and the markets are taking note.
2- The same phenomenon is observed in the inflationary trajectory. This is the second lesson from the past three months. While China grapples with growing deflationary pressures and Japan has never truly experienced a ‘peak,’ economists and central bankers have recently multiplied their contradictory views on the dynamics of prices on both sides of the Atlantic: rebound, persistent plateau, gradual decline, or rapid fall, everything is on the table. However, long-term rates tend to converge towards the anticipated growth rate, to which inflation expectations should be added. When uncertainties are high on both fronts, it means that both volatility engines are running simultaneously.
3- But the most significant lesson that the bond market is offering us in recent days is the gradual reversal of the infamous ‘yield curve inversion,’ which occurs when short-term rates are higher than long-term rates. However, the longer and more pronounced the yield curve inversion, historically, the higher the probability of a recession. This ‘uninversion’ is, therefore, good news as it indicates that the scenario of a severe economic slowdown is receding.
But for this trend to be confirmed, it would still require central banks to promptly initiate an actual interest rate reduction cycle, which would help lower the short end of the curve and definitively end its inversion.
This is highly desirable because, beyond expert debates, the only real threat that could genuinely reignite inflation in Europe and the United States today comes from a potential disruption in the supply and global value chains.
This can arise not only from the already observed increase in freight prices due to the situation in the Red Sea but also from a potential surge in energy prices in the event of geopolitical tensions in the Taiwan Strait or Eastern Europe. Furthermore, even though the prospect is diminishing day by day, there could be pressure on commodity prices if there is an extravagant economic stimulus in China.
However, it is primarily on demand that central banks act when they tighten financial conditions. This action was justified post-COVID when demand support plans were multiplying on both sides of the Atlantic. That period is now over.
Central bankers must therefore acknowledge this without hesitation to avoid a ‘reverse 2022’: delaying rate cuts for too long and then having to move too quickly and too aggressively afterward. The markets have set the groundwork for a new cycle; they now await the signals from Jerome Powell and Christine Lagarde to move forward.
By Wilfrid Galand