The yield curve and inflation

Things looked dire this time last year. Mass layoffs, closed borders, the prospect of lockdowns and, who can forget, toilet paper shortages! If you had asked most economists for a forecast you would have received a very gloomy picture. It was meant to take years to get back to full employment, house prices were going to crash, and the share market was fraught with risk.

Fast forward 12 months, and we might be living in a parallel universe. The share market is hitting record highs, house prices are rising rapidly and there is talk of inflation being around the corner, something scarcely observed in developed economies for a generation. What is going on?

The key variable here is the enormous policy response from central banks and governments around the world, unprecedented in peacetime. The Reserve Bank of Australia (RBA) and the US Federal Reserve were quick to respond to the pandemic by slashing rates to record lows. They also implemented unconventional policy tools. These actions put upward pressure on asset prices. For housing and the share market, bad news really has been good news.

Normally when people talk about the RBA setting interest rates, they are referring to the overnight cash rate target. This is approximately equal to the rate at which banks can borrow money for one day, and variable mortgage rates in Australia are quite closely correlated with this. However there are a whole series of different interest rates, depending on who is borrowing and for how long.

Governments and corporations, much like fixed rate mortgage holders, borrow for much longer periods and like to lock in their cost of funding up front. The Commonwealth borrows through the Treasury bond market, and the average maturity of its bonds is currently around seven years, with some as long as 30 years. Given interest rates for long borrowing periods can be very different from short term interest rates, these long maturity rates are very important for the economy too.

And that is where the RBA comes in. In addition to cutting the cash rate, the central bank implemented a policy known as Yield Curve Control, promising to buy government bonds in order to put downward pressure on bond yields. A target of 0.25 per cent was placed on three year Commonwealth government bonds, subsequently reduced to 0.1 per cent, with longer dated bonds trading more freely. This made it cheap for the government to borrow money to fund its budget agenda, and signalled to markets that the cash rate would be on hold for a long time.

At the end of April this year, bond yields in the zero to three year part of the curve were still nailed to the ground by Yield Curve Control, however longer dated yields had risen dramatically compared to a year ago. In financial markets this is referred to as “curve steepness”. A steep curve can occur for lots of reasons, but it usually happens during the recovery phase after an economic shock, and can be a prelude to rising short term interest rates. In fact, to find a time when the curve was as steep as it is now, we have to go all the way back to 1992, which was immediately following “the recession we had to have”.

So if bad news is good news, then what exactly is good news? If the steepness of the yield curve is a predictor of things to come, and it might be, then good news might mean higher interest rates, which could be bad news for the assets that have benefited from COVID-era monetary policy.

Central banks are typically much quicker to react to bad news than they are to react to good news, after all, nobody likes to be the one to take the punchbowl away. Right now, assets like stocks and housing are benefiting from being in the “sweet spot”, supported by the trifecta of a low rates, a recovering economy and low consumer price inflation. The variable to watch is inflation. Should we start to see inflation emerge, central banks will eventually have to raise interest rates. If the yield curve is to be believed, this may happen sooner than people think.