Since the Covid-19 pandemic erupted, investors have had more than their fair share of thrills and spills. Yet, it is no exaggeration to say that last week was the most momentous week in global markets since central banks and governments unleashed trillions of dollars of support to prop up the financial system and counter the economic shock of the virus. For the past several months, leading central banks, in particular the US Federal Reserve, have been tilting in a hawkish direction as it became clear that the surge in inflation was more persistent than anticipated. However, as recently as early January, the degree to which policymakers were willing to prioritise quelling inflation over supporting growth remained unclear. Over the past two week, markets gained a lot more clarity. In a dramatic policy shift, central bankers in America, Britain and the euro zone indicated that they had lost patience with inflation. The Fed all but confirmed it would begin hiking rates next month, while the Bank of England delivered its first back-to-back rate increase since 2004, and even debated raising borrowing costs by half a percentage point. In a sign of the extent to which policymakers are worried about price pressures, the more dovish European Central Bank – which had been most wedded to the view that inflation was transient, and had previously played down the likelihood of a rate hike in 2022 – declined to rule out a rise in borrowing costs later this year. The abruptness of the more hawkish stance from some of the big central banks startled investors, most of whom had been in the transitory camp when it came to inflation and were forced to quickly readjust their expectations for monetary policy. Among the most dramatic moves in markets last week was the plunge in the global stock of negative-yielding bonds, which dropped by nearly US$3 trillion in just two days, to US$5 trillion, down from a peak of almost US$18 trillion at the end of 2020, data from Bloomberg shows. More worryingly, the government bond yields of heavily indebted southern European countries, in particular Italy, rose steeply, rekindling long-standing concerns about the stability of debt markets in the euro zone once stimulus is withdrawn. The policy shock, moreover, came just when high-flying technology stocks were under pressure. The sudden shift in market expectations contributed to the staggering US$251 billion erased from the market value of Facebook parent Meta Platforms last Thursday, the biggest one-day fall for a US company on record. While the fierce sell-off in bond markets shows investors are coming to grips with higher rates, the speed at which central banks shifted to a tighter stance, and the aggressive repricing of monetary policy, have created a climate of excessive hawkishness. To be sure, the withdrawal of stimulus after years of ultra-cheap money was bound to be messy. Yet, what was not anticipated was that bond markets would be more hawkish than the central banks themselves. In addition to the risk of a policy mistake, investors must now contend with a self-induced market rout. Few would dispute that central banks underreacted to the surge in inflation and are now playing catch-up. However, the real threat right now is an overreaction by bond markets. In the US, traders are pricing in five rate hikes this year, with some Wall Street firms predicting as many as seven, compared with the Fed’s estimate of three. By galloping ahead of the Fed, bond markets are precipitating a tightening in financial conditions that risks becoming disorderly. Excessive hawkishness poses a huge threat to America’s stock market, which is eye-wateringly expensive. In a report published this week, Bank of America warned that the Fed is “tightening into an overvalued market”. Sentiment could deteriorate much more sharply if the closely watched corporate debt market, which has begun to show cracks, comes under strain. How big is China’s hidden debt problem, and what is Beijing doing about it? Exaggerated fears of tighter policy could prove even more damaging to the euro-zone economy, whose bond markets are far more reliant on super-loose policy to help keep the bloc intact. Markets are now pricing in at least one rate hike this year, partly because of the perception that the ECB will not be able to withstand tightening in the US and UK. Even in Asia, where inflation rates are much lower, the rapid adjustment in market expectations for rates in Europe and the US is fuelling concerns that the region’s central banks are falling behind the curve. This creates a dangerous situation in which jittery bond markets perceive Asian monetary policy through the prism of the Fed and the ECB. Central bankers in Washington and Frankfurt are to blame for the suddenness of the hawkish shift. However, bond investors are jumping the gun in pricing in much tighter policy than previously anticipated. If there is a brutal sell-off in the coming months, markets are likely to be more culpable than central banks. Nicholas Spiro is a partner at Lauressa Advisory