Policymakers want to create economies that are neither so hot that inflation returns, nor so cold that deep recessions are generated.

Nobody knows whether this can be achieved. But what does seem likely is that market sentiment will veer from one side of this debate to the other, probably producing quite a bit of volatility in the process. We continue to feel reasonably optimistic that policymakers can avoid the hot and cold extremities but it is still a tough ask.

Right now, the prevailing sentiment seems to be that policymakers might be veering too much to the “hot” side, meaning that economies won’t be slowed sufficiently to bring inflation back to target in a sustainable way. That’s not because recent inflation data have been disappointing.

In fact, measures of global inflation surprises appear to have shown consistent improvement over the past year, or so, following a long period when the market consistently underappreciated the amount of inflation in the global economy. Of course, improvement in core inflation, which excludes food and energy for most countries, has not improved at anything like the pace of headline inflation, but we would not expect it to. Despite this, it is difficult to argue that recent inflation data have been disappointing in either headline or core terms. Instead, what has happened is that data on the real economy has been a bit more robust than generally anticipated.

For example, Q2 GDP data has been stronger than anticipated for each of the US, euro zone and UK. And while survey data for the manufacturing sector still suggests widespread recessions here, the much bigger services sector seems to be holding up quite well in a number of countries. The corollary of this is that there’s been a reduction in the implied probability of full-on recessions in G10 countries.

While we might expect such news to encourage riskier assets such as stocks and corporate credit, there has been little such cheer, in part because the markets seem concerned that economies could be too “hot” and so risk a return to higher inflation and more policy tightening. The fact that many commodity prices have risen could be seen as testament to the fact that traders and investors anticipate a return of higher inflation or, at least, a cessation of the fall. The upshot is that both bonds and stocks have suffered as sentiment leans towards the idea that economies may be running too hot. But is this sentiment likely to continue and even intensify so putting asset prices at risk of a really deep rout, and not just the modest decline we’ve seen recently?

Mr. Steve Barrow, Head of Standard Bank G10 Strategy does not believe so. There is still plenty of monetary tightening to come through the pipeline from prior rate hikes, particularly in those countries where the prevalence of fixed rate mortgages means that households have yet to feel the full force of rate hikes. In addition, the signals from the labour market continue to point to an unwinding of the tightness in the employment situation.

However, this is coming through quite slowly and one thing that financial markets often tend to lack is patience, perhaps especially as risk assets such as stocks have already enjoyed a good year so far in most countries, leaving investors seemingly unwilling to maintain the sort of patience that may be required to determine whether this fall in inflation and slowdown in growth will prove too hot or too cold.

“Investors in bonds may be even more frustrated as hopes for a rally here have been high, but ultimately frustrated even though inflation has come down. If frustration turns to hefty sales, we could find that bond yields move significantly higher but that’s not our base case. In fact, we’d argue that current yields look attractive on a longer-term basis”, said Mr. Steve Barrow.