(Repeating item sent previously with no changes to text; the
opinions expressed here are those of the author, a columnist for
ORLANDO, Fla., Oct 15 (Reuters) - The U.S. and UK bond
markets are sounding the economic alarm bell.
Yield curves in both markets are flattening dramatically,
indicating that traders are pricing in a growing risk of a
central bank policy error or an increasingly gloomy outlook for
The eye-catching moves are being driven by the long end of
the curve, where 30-year yields are falling sharply. At the same
time, traders are bringing forward forecasts of the first
inflation-fighting interest rate hikes from the Federal Reserve
and the Bank of England.
Even though policy rates are at the zero lower bound and are
unlikely to rise much after liftoff, premature tightening to
fight supply shock-fueled inflation could still choke growth and
tip economies toward recession.
The European Central Bank's infamous rate hikes of 2011,
which deepened the region's debt crisis and triggered a
recession, are mistakes no central banker wants to repeat.
Yield curves flatten when the gap between short- and
longer-dated borrowing costs shrinks, and they invert when
longer-term yields fall below shorter-dated yields. Both
scenarios, particularly inversion, often precede slowing growth
and sometimes recession.
It is in that context that Wednesday's moves bear a closer
In the United States, the 10s/30s curve flattened below 50
basis points for the first time since the outbreak of the
COVID-19 pandemic in March 2020.
The 2s/30s curve flattened 9 basis points for the second day
in a row. The cumulative 18 basis-point fall is one of the
biggest two-day declines in over a decade.
The UK 2s/30s spread, meanwhile, narrowed by 15 basis points
on Wednesday, the most in a single day since March 2020 and one
of the biggest drops in a decade.
The 10s/30s curve compressed to just 23 basis points, the
flattest since the dark and volatile days of late 2008.
This comes against a backdrop of the highest inflation in
years and financial markets bringing forward the timing of the
first rate hikes. Rates markets now expect the BoE to move this
December, and the Fed in September 2022.
Flattening yield curves suggest the bond market thinks this
A Deutsche Bank survey of more than 600 market professionals
this month showed that a central bank policy error is now the
second biggest risk to market stability, behind higher bond
yields and inflation, and ahead of growth concerns.
Intriguingly, more think the Fed's error would be a dovish
one, keeping policy too loose. Ultimately, however, the economic
damage may be similar to a hawkish mistake, as high inflation
would squeeze consumer income and corporate profits, choking
But tightening too early or too much is probably the greater
gamble, which is why the Fed may be inclined to allow inflation
to run a bit hotter now in order to minimize the much more
destabilizing risk of deflation when the next recession hits.
"The Fed can do some real damage by moving too quickly,"
warns Scott Kimball, co-head of U.S. fixed income at BMO Global
Minutes of the Fed's September policy meeting published on
Wednesday showed that "various" participants think economic
conditions justify keeping the fed funds rate "at or near its
lower bound over the next couple of years." Many of them said
there will likely be "sustained downward pressure on inflation
in the years ahead."
On the other hand, "a number" of participants argue that
labor market and inflation conditions will allow the Fed to
start raising rates by the end of next year. Some of them expect
inflation to remain elevated in 2022, with risks to the upside.
What is the larger group, "various" or "a number" of FOMC
Over in Britain, as the Deutsche Bank survey shows, the risk
appears to much more clear-cut: The BoE will raise rates too
Futures markets are now almost fully pricing in a
15-basis-point rate hike in December, a full quarter-point hike
by February and 50 basis points by May.
Bank officials have done little to push back on these
aggressive market expectations. Their silence has only fueled
the frenzy, and rowing back now would likely damage their
There is an argument to be made that pre-emptive rate
increases are needed to anchor inflation expectations, thereby
limiting the eventual number and scale of increases.
But as Ross Walker at NatWest Markets wrote during the
weekend, "choosing to choke off domestic demand in order to
arithmetically offset external cost pressures is a depressing
"If there is to be monetary policy error premature and
excessive rate rises it will be in the UK."
(Reporting by Jamie McGeever; editing by Jonathan Oatis)