It would not be surprising if the major swings in the markets and macroeconomic conditions, including historic central bank shifts, have made most investors somewhat seasick. Recently on a day-to-day basis, markets seem to react quite irrationally, but the overall backdrop is fairly clear: the markets are getting accustomed to one of the most rapid and major shifts in Federal Reserve policy ever in its history. Combined with the guidance of imminent hikes and QT, there has been nearly 250 bps of implied tightening for 2022, and almost as much for 2023, all within the last month or so. The Fed was behind the curve, and has even come close to admitting such, so it knows that it needs to catch up fast. The uncertain economic outcomes of COVID variants and the way the pandemic has changed labour force participation were major reasons for the Fed to be cautious about tightening, so it is unfair to be too critical with 20/20 hindsight. However, its new inflation-overshooting policy, coupled with various policies that have restrained oil production, has emboldened commodity speculators, especially when any shortages arose, and overall purchasing philosophy strongly in an inflationary direction. In other words, the inflation policy worked so well that it has engrained an inflationary psychology, including wage demands that are leading to second round inflationary effects. For this reason, some of today’s inflation is temporary, but quite a bit is not, and upward pressure remains.
Thus, the markets remain nervous about any further tightening that might be broadcast, but for the time being, it seems bonds and equities have priced in five 25 bps hikes in 2022, three more in 2023, and a few in 2024 to get the Fed funds rate close to a neutral rate. That seems a very long time to get to neutral, even assuming the CPI and its core rate decelerate to 3.0% by the end of the year, but one must also account for the tightening from QT of about USD 80–100 billion/per month starting around midyear. Some bond market specialists are likely betting, given their pessimistically oriented asset class, that risk markets will not be able to absorb all this tightening, and, thus, bond demand will rebound. But given the recent risk asset stabilisation, with consensus forecasts of a 10-year UST at 2.2% by year-end, it is not likely wise to be bullish on bonds at present levels. Moreover, a geopolitical crisis does not necessarily help bond prices, as such could prove quite inflationary.