Central banks prepare to raise interest rates to 15-year highs.

Leading central banks are expected to increase interest rates this week to their highest levels since the financial crisis, which is fueling concerns among some investors that the bond market rally this month has underestimated signs of persistent inflation.

Since the beginning of the year, bond prices have quickly recovered from last year's unprecedented sell-off as markets have wagered that interest rate increases will be muted or, in the case of the US Federal Reserve, even reversed. However, some investors are unsure.

According to Monica Erickson, head of investment grade credit at DoubleLine Capital, "I think it is just a matter of the market kind of waking up to what the macro environment really is, as opposed to what they hope it is. [It] is going to be super difficult again for the Fed to . . . get inflation down to that magical 2 per cent number without putting us into a recession."

"The credit markets are effectively pricing in a no-recession outcome. But that’s not the consensus base case that most economists are forecasting ," according to Maureen O'Connor, global head of Wells Fargo's high-grade debt syndicate.

In 2023, a Bloomberg index that tracks high-grade and junk-rated corporate and government bonds globally has returned 3.3%, putting it on track to have its best January since the index's inception in 1999. According to EPFR data, inflows into US and western European corporate bond funds reached $19.3 billion as of January 26 and are expected to have their highest January ever.

This week will see policy meetings at the Fed, the ECB, and the Bank of England. Investors anticipate the Fed will increase rates to their highest level since September 2007, when the global financial crisis began, by slowing the pace of its monetary tightening to 0.25 percentage points.

Rate increases from the BoE and ECB are widely anticipated to bring them to their highest levels since fall 2008, when Lehman Brothers filed for bankruptcy.

The gap between investor expectations and economic reality is expanding, and there are more signs that underlying price pressures are proving tenacious in the face of these swift and globally coordinated rate increases.

Market indicators of inflation indicate that traders now anticipate inflation to eventually decline close to the 2% Fed and ECB objectives.

However, price growth is still at 6.5% in the US and 9.2% in the eurozone. Core inflation, which central bankers constantly monitor and excludes volatile prices for food and energy, is still high.

Despite recent decreases, surveys suggest that consumers and companies in the majority of industrialized economies anticipate inflation to remain higher than central bank targets in the medium run. These indicators, along with market-based measures of expectations, are frequently monitored by policymakers because they have the potential to increase inflation by feeding wage demands.

According to Nathan Sheets, chief economist at US bank Citigroup, "inflation expectations can be a self-fulfilling prophecy, as higher expectations trigger the inflationary conditions that are envisioned." "Ensuring that inflation expectations do not ratchet upward from here" was the main concern of central banks.

"On almost all measures, inflation expectations are still much higher than their pre-pandemic levels and above the levels that would be consistent with the major banks' 2% inflation targets," said Jennifer McKeown, chief global economist at Capital Economics.

The bond market rise could falter if central banks maintain high rates for an extended length of time or raise them more than investors anticipate.

The 10-year US Treasury yield, which serves as a benchmark for borrowing prices around the world, has decreased to 3.5% from 3.9% at the end of December. As a result, corporate bonds, which normally give better returns than their government counterparts, are more appealing.

Since the beginning of January, credit spreads, the premium that investors demand to hold corporate bonds over high-grade government paper, have decreased. So far this year, the yield spread between US investment grade debt and Treasury notes has shrunk by 0.1 percentage points.

Spreads on high-yield bonds with lesser ratings have shrunk by approximately 0.6 percentage points, tightening even further.

According to O'Connor, the investment grade market is currently fairly priced for perfection. "I worry about the black swan events and the catalysts that could catapult spreads wider from here."

These worries have not stopped a flood of cash from flowing into the bond market.

According to Rick Rieder, chief investment officer for fixed income at BlackRock, "there is a lot of money chasing yields. In an environment where growth is slowing, where the equity market is not appealing, people are saying — there is an attractive yield and I can lock this rate up."

By fLEXI tEAM