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The tight relationship that has held between long and short bonds for the last 12 months is breaking down. Curves are normalising.
What is happening?
When long interest rates moved higher early last week in response to unexpected strength in economic survey reports, short rates did not. When short rates subsequently moved lower later in the week, following weak US employment data, long rates reversed their rise only reluctantly and by commensurately less. This is a change in dynamic that has been coming increasingly to the fore in recent weeks and one we have been expecting.
Why does it matter?
It signals that markets believe not only that substantial rate cuts are coming, but critically, that these rate cuts will, in time, facilitate monetary growth that is sufficient to support the economy.
Why have rates been diverging?
Inflationary and economic momentum have been in cyclical decline this year, indicating that interest rates are tighter than they need to be right now. As a result, we expect central banks to bring short rates down to levels that are unlikely to be sustained over the full economic cycle. Moreover, there is greater uncertainty today than in recent economic cycles as to the extent to which we will see price inflation rise once growth momentum resumes. Hence, long maturity bond yields have not embraced the rally to the same extent as have those of shorter maturities.
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