Against this backdrop, and as heavily trailed would be the case, this week the Fed, the Bank of England and the ECB all moderated their recent aggression with interest rates, raising them in each case by a half-point rather than three-quarters. Those new interest rates now stand respectively at 4.5%, 3.5% and 2.0%. It is worth bearing in mind that the starting points were effectively zero in the US and the UK, and -0.5% in the eurozone, all within the last 12 months.

Where the markets and policymakers differ in opinion is over what happens next. While less aggressive than previously in implementation, the Fed’s tone remains hawkish: the accompanying statement to the December policy meeting was unrelenting in maintaining that rates will continue to rise in 2023, likely as high as 5%, possibly even 5.25% or above. That itself is not particularly contentious (though diverting the emphasis from the core inflation mandate, Powell was vague about the other economic indicators he and the committee are considering as confirmation that stability is being restored). However, many market commentators had been forecasting/hoping that when rates reach their peak, the interest rate path would take the shape of an inverted ‘V’ and rates would immediately begin coming down. Powell clearly disagrees. The speed of rate rises is no longer the issue, it is the duration and stability of high interest rates. His latest statement warns that the Fed’s current thinking is that when they reach their terminal level, we should be ready for US interest rates staying at that yet-to-be-determined plateau for some time, at least into 2024 before they gradually trend lower (as a reminder of how dynamic the system is and how much has changed in a very short time, in May of last year he was forecasting in his forward guidance that he fully expected to be continuing quantitative easing well in to 2023 and that interest rates in the US would still be at zero at the beginning of 2024. It was a pious and naive hope!).

As to the economic consequences, it’s not just about the extent to which higher interest rates temper consumption, slow the momentum and potentially put pressure on government tax revenues. There is also the direct financing cost. As at November, and before the latest interest rate increase, the US government disclosed it was paying $103bn in annualised interest charges (11% of all Federal expenditure) to maintain government debt; incidentally that ignores all the debt owed by US companies and individuals. Were interest rates to rise and the debt to remain the same, a terminal rate of, say, 5.25% would cost a further $30bn, nearly 14% of the Federal budget, stretching the public expenditure elastic even further.

So, what have markets made of it all? US Treasury yields fell on the better-than-expected inflation news; days later they barely moved an iota on Powell’s determinedly hawkish statement. Like the jury leading the judge, markets are implying that having been too optimistic about inflation in 2021, Powell is being too pessimistic about the outlook for 2023. They’re telling him that not only is he wrong but as they did at the end of 2018 (in very different circumstances) they are also trying to get him to execute a swift U-turn (more accurately a ‘V-turn’!), a second ‘Powell Policy Pivot’.

As ever, there are no hard absolutes here, not least because the economic system is dynamic. Add to which, more often than not there is a reaction when the official Federal Open Market Committee board minutes are released and analysts pore over the detail and nuances of the discussion. But one thing remains unambiguous in fixed income investors’ minds: the risk of recession and if it happens, how bad it will be. Indeed, their perception of such a likelihood has hardened in recent days. The evidence lies in the inverted yield curve we discussed last week (and in several editions prior to that).

Government bond yield curves typically track from bottom-left to top-right when looked at on a graph; investors usually require a higher rate of return the longer the bond takes to mature (as measured in the number of years to redemption, i.e. ‘duration’) to reflect the greater uncertainty the further one looks to the future; when the curve is inverted and shorter duration bonds have a higher yield than longer ones, the perception is that the shorter-term economic risk is of greater concern; an inverted curve is not a hard predictor of a recession but it is a good barometer of the possibility or likelihood of one happening. Indeed, by pushing up short-term funding costs it can help make it a self-fulfilling prophesy.

Dominated by the effects of the pandemic and Putin’s war, the US yield curve’s inversion in this cycle is nothing new; it has been a feature for several months. But what is new is the extent to which the inversion has been gradually creeping further ‘in’. If a few months ago it was the 5-year Treasury bond whose yield exceeded that of the 30-year (currently 3.5%) so that has gradually come sequentially to include the 2-year (4.2%), the 12-month (4.6%) and the 6-month (4.7%). Even the three-month yield (i.e. for redemption in March 2023) exceeds the required annual rate of return over 30 years.