When the Bank of England made a surprise last week by keeping rates unchanged, the impact quickly spread beyond UK government bonds.
The subsequent rally in the gilt market, when traders canceled their bets on rate hikes in the UK, also slowed yields on Eurozone and US Treasury bonds.
The episode shows how a group of smaller central banks – led by the BoE, but also the Bank of Canada and the Reserve Bank of Australia – have recently found themselves in the unusual position of dictating movements in the world’s largest bond markets.
“We have seen on a number of occasions now that these central banks, normally on the fringes of global markets, are in the driver’s seat,” said Richard McGuire, Rabobank’s interest rate strategist. “It’s definitely the tail wagging the dog.”
Some investors attribute the unusual pattern to the perceived contrast between the softly wired sliding of the US Federal Reserve to reduce its security purchases or the consistent reluctance of the European Central Bank and a series of screeching handbrake movements by smaller central banks.
The BoE was the main protagonist, rocking UK and global bond markets when it first hinted in September that rates could rise this year, further fueling expectations of a quick tightening with a series of public comments from policymakers ahead of it They were nullified by their resignation last week, tariffs on hold. Last month, the RBA itself caused a stir by blowing bond yields beyond their long-held target, while the BoC made waves by abruptly abandoning its bond-buying program.
Even so, the spectacle of these relative central bank minnows in charge has caused some headaches. As one US portfolio manager put it, “The Bank of England is not increasing. . . Strange as it sounds, was a great catalyst [for the rally in Treasuries]. I say ‘strange’ without offending our British friends. But dude, you are not that important. Why are you driving our market? “
The answer lies, in part, in a common challenge central bankers around the world face: how to respond to a rapid surge in inflation without overreacting to stall economic recovery. Given that monetary policy in developed countries has been largely in step for years, Fed and ECB observers are looking at smaller – and often more nimble – central banks for clues as to how the big beasts will react to the dilemma.
“The central banks have been in sync for so long that people can’t imagine anything else,” said Andrea Iannelli, investment director at Fidelity International. “Anyone who is not aligned is not considered an outlier, but a canary in a coal mine.”
Part of this “read-across” from the BoE to the other central banks was exacerbated by the positioning of investors, argues Iannelli. This is because investors, turned on the wrong foot by the moves in the UK, used Treasuries as a proxy for gilts when they rushed to exit losing positions. “You may not be able to do this in the size you need in the gilt market, so you buy bunds, you buy treasuries, you buy whatever you can,” he said.
The global nature of the government bond market, where investors regularly make relative valuations of the returns on offer in different economies, also means that movements in one market tend to ricochet off another.
“If interest rates are going to be higher in other countries and some of these global investors can stay home and make returns, that will matter [the US] Market, ”said Tom Graff, Head of Fixed Income at Brown Advisory.
However, the role of positioning or relative value of investors is limited by the size imbalance of the economies and bond markets involved. With a little less than £ 2 trillion UK government bonds outstanding, the gilt market is little more than a tenth of the value of the treasury market, IMF figures show. The bond markets of Australia and Canada are much smaller.
Instead, it is the clues that the shifts in these markets offer on the likely next steps for larger central banks – mainly the Fed – that have made them overly important.
“The rates market was driven by global monetary policy communications,” said Mark Cabana, head of US rates strategy at Bank of America. “The Bank of England in particular had a major impact on the US interest rate market, as inflation factors are more of a global nature. And if the central banks push back, the effects will be of a global nature. “
For now, that means the policy turns in the UK, Canada and Australia are likely to be subject to unusual scrutiny. Seema Shah, a London-based investment strategist for US wealth manager Principal Global Investors, said she recently received a spate of calls from US colleagues.
“People suddenly wanted to know about the BoE’s response function,” she said. “But there is still this underlying disbelief. They struggled to admit that this could all have started with the BoE. “
