ROI-Inflation-spooked rates markets have overshot: McGeever

(The opinions expressed here are those of the author, a columnist for Reuters.)

By Jamie McGeever

ORLANDO, Florida, March 25 (Reuters) - Markets overshoot, and the dramatic surge in bets on higher interest rates in light of the Middle East energy shock is the latest case in point: the move may be logical, but its magnitude is questionable.

As the dust settles on one of the busiest central bank weeks in years, the Iran war shows no sign of ending and markets remain in flux. It may be time for rates traders to take a breath and reevaluate.

The sudden change in the global rate outlook clearly reflects fears about the near-term impact of soaring oil and gas prices on inflation. The Federal Reserve is now more likely to raise U.S. rates this year than cut them, while the European Central Bank and Bank of England are now predicted to hike multiple times, possibly starting as early as next month.

The shift in Europe is worth zooming in on.

On February 27, the day before the joint U.S.- Israeli strikes on Iran, UK rates futures pointed to 50 basis points of easing by year end, or two quarter-point rate cuts. That has now flipped to almost 75 basis points of tightening, or three hikes.

A 125-basis point swing in a matter of weeks is extraordinary.

Meanwhile, euro zone rates futures have gone from implying that the ECB will keep its key policy rate on hold at 2% for the rest of this year to pricing in two rate hikes.

This hawkish trajectory could come to pass. Policymakers are still scarred from misreading the "transitory" inflation of 2021-22. But the last two times they raised rates with oil well above $100 a barrel - in 2008 and 2011 - they were widely accused of policy mistakes.

LIMITS OF 2022 COMPARISONS

Many analysts are drawing parallels between now and the energy shock sparked by Russia's invasion of Ukraine in February 2022 that helped fuel the worst bout of developed market inflation in decades.

But there are key differences.

Interest rates are significantly higher going into this crisis than they were in February 2022. At that time, G4 central bank policy rates were near the zero lower bound, with the ECB and Bank of Japan in negative territory.

What's more, inflation in 2022 was also being fed by trillions of dollars of pandemic-fighting stimulus and the burst of economic activity after lockdowns were lifted. Real interest rates in early 2022 were deeply negative.

That combination of super-easy fiscal and monetary policy meant inflation turned out to be far from transitory. In the U.S., it still hasn't returned to target despite the most aggressive hiking cycle in 40 years.

Fiscal stimulus is also in the cards today, with governments from Washington to Tokyo to Berlin set to spend heavily on defense and energy while slashing taxes. But these volumes will be nowhere near as big as the pandemic-fighting packages that were worth at least 10% of GDP.

GOLDMAN, CITI STICK TO U.S. RATE CUT VIEW

Economists at Goldman Sachs and Citi are among the dwindling band standing against the rising tide of forecast revisions and calls for the Fed to nip price pressures in the bud with a rate hike or two.

Jan Hatzius and his team at Goldman are still penciling in two Fed rate cuts this year, and Citi's Andrew Hollenhorst and team are sticking to their call for three cuts.

They argue that any incoming inflation burst will be short-lived, lasting maybe a few months, while the downside risks to growth and employment will run deeper. In essence, they anticipate a temporary supply shock that raises prices but deals a more lasting blow to demand.

There's already reason to believe this could be the case. Purchasing managers' index data on Tuesday showed that U.S. private sector output in March fell to its lowest in 11 months, overall activity in the euro zone fell to a 10-month low, and activity in Britain expanded at its slowest pace in six months.

Rates markets are right to be on edge given the speed and magnitude of the energy price shock. Still, it will be difficult to justify raising rates if growth is slowing and unemployment is rising, even if inflation is above target, as it is in the U.S. and Britain.

(The opinions expressed here are those of Jamie McGeever, a columnist for Reuters)

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(By Jamie McGeever; Editing by Marguerita Choy)