October 14, 2022 | By Hank Cunningham
Inflation is a global issue. In Europe, consumer prices are above 10% with no sign of relief. There has also been extra turbulence caused by extraordinary developments in the UK. There is little doubt that short-term interest rates and market bond yields are headed higher. The U.S. Federal Reserve has signaled at least two more hikes before year end, which would produce a Fed Funds Rate of 4.5%. Others believe the Fed will tighten further, with the Fed Funds Rate peaking next year.
As to market yields, the U.S. two-year yield, currently at 4.4%, could reach 5% with further tightening and the 10-year appears to be headed for 4.5%. There have been few signs of strains in credit markets but vigilance is required. Given the extent of the bond market selloff, it is likely there will be rallies from time to time.
The Fed has stated that it needs to see several consecutive monthly improvements in inflation statistics before reconsidering its policy stance. There is growing evidence of an acceleration in wage demands, which will act as a floor for inflation.
The Bank of Canada has little choice but to follow the Fed as the Canadian economy has also proved to be resilient. In addition, the Canadian dollar has suffered at the hands of a strong U.S. dollar; the weaker Loonie will exacerbate inflation trends in Canada as import prices add to domestic price pressures.
In summary, global credit markets have discounted the next rounds of interest rate hikes by central banks. This removes the surprise factor and should result in few knee-jerk reactions. There remains the possibility that several central banks may reduce their bloated balance sheets via bond sales.
The big question remains: when will we see inflation turn? Thus far, inflation has been slow to respond to tightening and, in fact, has accelerated somewhat. There is a six to nine month lag before monetary tightening takes effect, so it is possible markets will see some improvement on the inflation front in the first or second quarter of next year.