(Bloomberg) -- Traders in the world’s largest bond markets are heeding warnings from central banks and winding back bets on aggressive interest-rate cuts this year. 

Investors once virtually certain that the Federal Reserve would kick off an easing cycle in March now see the odds as no better than a coin toss. And Treasury yields have risen across the board after Governor Christopher Waller pushed back on the aggressive rate-cut bets — saying policymakers should move carefully — and a bigger-than-expected jump in US retail sales Wednesday underscored the economy’s strength.

A similar repricing is under way in the UK, where bonds tumbled after inflation unexpectedly accelerated, pushing up 10-year gilt yields by as much as 18 basis points Wednesday, putting them on pace for the biggest jump in almost a year. European Central Bank President Christine Lagarde added fuel to the selloff, saying in a Bloomberg interview that market bets on a big easing of policy are a distraction.

The comments are part of steady refrain from central bank officials striking a more cautious tone about the outlook for monetary policy easing. The latest rounds of data lent more credence to the warnings, highlighting the risk that premature policy pivots could sow the seeds of an inflation resurgence. 

“The mantra of the central banks is the same: we made progress, but we need to make sure inflation doesn’t back up again,” said Gregory Faranello, head of US rates at Amerivet Securities. “Financial conditions have loosened dramatically. They are pushing back, and the market is listening.”

The central bankers’ caution rests on several factors, from the relative resilience of employment and economies to concern that price growth will prove stickier and stay above targets. 

And many central bankers still have scars from the recent spike, having at first predicted that it would be transitory. Now, even with inflation having peaked in major economies, they are wary of underestimating the threat again and loosening too soon or too fast. 

Speaking in Davos on Wednesday, State Street CEO Ron O’Hanley said the health of the US labor market and the economy means the Fed is going to “err on the side of holding interest rates.”

“I don’t think the Fed would like to see a resurgence of inflation,” he said. “To me, the Fed was very clear in their dot plot. I don’t know why markets decided to double it and go to town on that. It doesn’t make sense.”

In the US, the selloff has hit the policy-sensitive two-year note the hardest. That pushed up the yield by more than 20 basis points over the past two days and flattened the yield curve, a typical reaction to a less dovish central bank. Futures traders dialed back the scale of Fed cuts expected in 2024 by about 16 basis points Wednesday to about 141 basis points.

Distractions

ECB’s Lagarde said while the central bank is likely to cut interest rates in the summer, market expectations of more aggressive easing could be counterproductive. 

“It is not helping our fight against inflation, if the anticipation is such that they are way too high compared with what’s likely to happen,” she said in an interview at Bloomberg House in Davos. 

Money markets responded by paring the extent of cuts expected from the ECB this year. They now see 137 basis points by year end — equivalent to five quarter-point moves, with a 50% chance of a sixth. There’s also less conviction that the first move will come as soon as April, seen as a certainty until now.

Supply Bottlenecks

Policymakers have reason to be wary. Disruptions to supply chains that began during the pandemic were partly behind an initial bout of inflation that occurred before energy prices spiked in the wake of the Russian invasion of Ukraine.  

“There is a growing realization that central banks won’t be rushing to cut rates quickly,” said Susannah Streeter, head of money and markets at Hargreaves Lansdown. They are “facing the foe of stubborn inflation and geopolitical risk is widening particularly in the Middle East, with no end in sight for shipping delays which threaten to lift goods prices.”

--With assistance from Greg Ritchie, Naomi Tajitsu and Anchalee Worrachate.

(Updates with US retail sales and market pricing from third paragraph.)

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