Why markets might be getting rate hikes wrong

The conflict in the Middle East has jolted fixed income markets, sending government bond yields higher globally with a hawkish repricing taking hold as markets grow nervous about the prospect of renewed rate hikes.

Yet BeiChen Lin, head of Canadian investment strategy at Russell Investments, sees a disconnect between what markets are pricing in and what central banks are likely to do. Across developed markets, yield curves have also flattened, he noted, as two-year yields in places like Australia and Germany have climbed faster than 10-year yields, reflecting heightened sensitivity to near-term central bank action. Still, Lin questions whether those market moves are justified.

"One of the things that we have to be mindful of is whether the market's recent moves align with our expectations and outlook for what central banks globally are actually going to do," he said, adding before the conflict began, most developed market central banks were already on a dovish path – rates were either at neutral or heading in that direction.

"Generally speaking, the historical playbook for a central bank is they often will tend to look through energy shocks. The reason for that is twofold. One is that energy is harder to control. Central banks can raise and lower interest rates, but energy prices are oftentimes dictated by other factors, not by what the central bank does. And as a result, their tools just don't work as well,” Lin explained. “The second reason is energy shocks oftentimes tend to be temporary in nature and central banks are more concerned, usually with maintaining inflation within he target range over a medium term, rather than necessarily stomping out every last inch of temporary inflation.”

The obvious pushback is 2022, Lin suggests, when central banks dismissed inflation as transitory and then scrambled to catch up with some of the most aggressive rate hikes in a generation.

"Central banks are very conscientious of that past experience, and it's likely that some market participants are thinking well because of that, maybe this time central banks are going to have a much tighter leash on inflation," he added.

Still, Lin argues markets may be reacting too aggressively by treating the latest energy shock as if it were a replay of 2022. He sees one clear similarity between then and now: a geopolitical conflict that’s pushed energy prices higher. Beyond that, though, he thinks the backdrop is very different.

In 2022, the world was still reopening, demand was surging after Covid, labour markets were overheating, and housing was still strong. All of those forces helped spread inflation more broadly through the economy.

He suggests that’s not the case now. Notably, labour markets in the US look more balanced, while countries such as Canada and the UK are showing signs of softness. Housing has also cooled, which should limit further pressure from shelter costs. He believes that leaves energy as the main remaining channel for inflation to run hotter.

That matters because if the Middle East disruption proves short-lived, the inflation impact should also be temporary. Lin’s base case is that central banks will have room to look through the shock rather than respond with fresh rate hikes. He sees a low probability for the Federal Reserve to tighten again and thinks a hold is more likely, with the possibility of a further cut if the disruption fades.

He’s even more forceful on Canada as Lin believes the market is far too hawkish in pricing roughly three Bank of Canada hikes. He points to the Bank of Canada's own messaging as evidence that the market has it wrong. After all, Governor Macklem, at his most recent press conference, reiterated that central banks can look through temporary inflation provided expectations remain anchored.

"He continues to note that the Canadian economy is running in a state of excess supply. In other words, the Canadian economy is still running below potential. Inflation was starting from a point where it was already very close to the Bank of Canada's target. And the unemployment rate is above that longer term trend," he noted, adding the lingering uncertainty from CUSMA adds another drag, discouraging businesses from hiring or spending on capital expenditure.

"I think even one rate hike by the BOC this year is very unlikely, let alone three. And in fact, I would continue to argue that there's probably a higher chance that the BOC has to cut rates at some point this year instead of hiking interest rates,” said Lin.

That view feeds directly into his fixed income stance, which he acknowledged is creating “some attractive valuations in Canadian government bonds.” He sees more value in government bonds outside the US, especially in Canada, where yields look cheap relative to his fair value estimate.

He argues 10-year government bonds are trading meaningfully above his fair value estimate, which suggests markets have become too aggressive in pricing a hawkish path for rates. He extends that view beyond Canada to markets such as Australia and the UK, where he also sees better value than in US Treasuries.

As for corporate credit, Lin is more cautious, noting spreads were already very tight before the Middle East conflict, especially in US investment-grade credit. Although spreads have widened slightly since then, he doesn’t think they’ve moved enough to look compelling by historical standards. Still, if that widening continues and valuations return to something closer to normal, he suggests there could be room to reduce that underweight.

The key distinction in his view is that corporate fundamentals remain solid, with profits holding up well in the US and elsewhere, but valuations are still doing a lot of the work. Because spreads remain so tight, he believes the risk-reward trade-off still favours government bonds over corporate bonds.

While both the two-year and 10-year parts of the Canadian government curve look attractive in his view, “the two-year is going to be the most sensitive if we do get a reversal in pricing in the markets," noted Lin.