A delusional market continues to take on risk while volatility spikes in bond markets

Inflation and central banks' monetary policies might be a brutal wake-up call for investors.

As the conflict in Ukraine intensifies, markets are forced to reconsider growth forecasts. Yet, to prompt the need to pare back interest rate hikes is not only the uncertain macroeconomic outlook but the much less hawkish statements of central banks officials.

Yesterday, money markets pushed back on ECB rate hikes for this year, pricing the first hike in March 2023. It provoked a considerable rally in European sovereign bonds, especially in the periphery, where we saw the BTP-Bund spread falling below 150bps. However, today's rate hike bets reverted as the Eurozone CPI figures for February beat expectations hitting a new record high. Markets returned to consider two rate hikes by December. However, volatility and uncertainty remain incredibly high, meaning that the tightening outlook can change every time unless the ECB outline a clear path towards normalization.

Gilt yields dropped the most in the UK since the 2016 referendum on Brexit as the market went from pricing more than six rate hikes by December to less than five. In the US, expectations for the terminal rate fell to 1.7%, while the Federal Reserve's long-term estimate is at 2.5%.

We are in front of a market that continuously rebalances expectations depending on growth and inflation. However, the freeze of assets under the Russian central bank might be playing a considerable role in adding volatility to bond markets.

We expect central banks to keep focused on inflation, which is becoming a systematic problem that will require tighter monetary policies sooner or later. The later central banks begin to react, the more aggressive they will need to be, causing even more market volatility. That is going to be a wake-up call for investors, especially for those who continue to take on risk or buy the dip, hoping that central banks will rescue them in the long term.

Reinforcing the idea that inflation has become a systematic risk, real yields plunged into deeply negative territory. Ten-year TIPS yields broke their 200 days moving average at -0.92% to recover some of the losses later in the day. The move has been driven by dropping nominal yields and rising breakeven rates. Real yields are telling us that investors are afraid the Federal Reserve will not contain inflation with a moderate pace of rate hikes.