January 14, 2022 | By Hank Cunningham
This year is shaping up to be the year of “the Hike.” Central banks have come to realize that they are behind the curve and are moving to rein in excessive monetary accommodation. At present, the Bank of Canada may move first. The first increase in the Fed Funds Rate could take place in March, when quantitative easing is slated to end. The markets anticipate three or four yield hikes, which would put the Fed Funds Rate over 1% by year end.
Real yields (bond yields minus inflation) are at extremely negative levels. As inflation ameliorates and nominal bond yields rise, real yields will improve (i.e. become less negative).
Wage pressures are escalating and may prevent the inflation rate from falling back to the 2% level. Commodity prices have soared of late too. Long-term deflationary pressures, such as demographics and technology, will re-emerge and help ease inflation. Overall, inflation will be slow to subside, with most forecasts estimating it to land between 3-4%.
The runoff in the Fed’s balance sheet plus the massive increase in corporate borrowing should add to upward pressure on bond yields. The ten-year U.S. note should grind higher to 2% or more. The key question is whether the economy reacts poorly to this tightening. The Fed must act gingerly and could act more slowly than consensus.