Let us try some answers to these questions. First, the triggering point of the sell off seems to be the poor productivity numbers released early in the week in the US, a new view on the state of the US/EU economies together with an unexpected interest rate hike by the Central Bank in New Zealand (CBNZ). Higher inflation expectations have been built over the last two weeks as both the US and EU economies have shown signs of strong recovery. In relation to the catalyst nature of the unexpected interest rate in New Zealand some might say that New Zealand is too little of a country (economically) and too far away (also economically speaking) to be considered a cause. This is true. But when all Central Banks join voices on inflationary pressures (as they did last week), and an unexpected action by a Central Bank is taken, no matter how small it is, this brings back memories of unexpected movements by the Fed. Just remember that the last easing cycle was initiated by an unexpected drop in the Fed fund of 50 basis points. Hence the movement from the CBNZ might have just brought to the mind of many bond managers a real possibility: an unexpected interest rate movement. The violence of the movement (25 basis points in two days) might have been caused by the natural overreaction on financial markets together with unexpected hedging needs (people taken on the wrong side, risk extension from some mortgage backed securities, convexity hedging needs…).

Second, what might be the consequences of this market shift? This movement will definitely push up mortgage rates renewing the pressure on an already weak US housing market. Higher yields would increase the cost of any new debt issuance putting downward pressure on investment spending and hitting corporate profitability. Some M&A activity might slow down as debt cost start rising. All this might affect stock market sentiments. When bonds were falling last week, stocks also were in the red. This movement will be more pronounced the more inflation expectations accelerate. As further term premiums get built back into the curve to discount for these component risks, the movement will widen.

Third, is this long term yield repricing a long term movement? The consensus seems to be that the inflationary premium will be built into long term yields and the age of easy money and cheap liquidity will fade away. Some stubborn minds still believe in a change in the Fed’s view guessing rate cuts within the year. They reason as follows: as long economic growth stays weak, and inflation is tamed the Fed may lower six months down the road as the housing market deteriorates. Those that hold this view are fewer and fewer in the market, and at the end is the market that sets the tone.