Rates Spark: Bonds braced for another inflation pop

The US 10-year has just touched 4.7%, and there is no sense that it looks mispriced. The 10-year term premium is still close to zero. Back in October, it was 40bp. Add that back on and we have a 5% handle in a flash. The GDP report on Thursday was all about the inflation component, which, again, was hotter than expected. And the prior expectation was hot in itself. Further evidence that the Fed can’t cut here. The FOMC meets next week, and if they were to do anything, it would be a hike! (but they will do nothing). If we get 0.4% from the PCE deflator tomorrow we will have further confirmation of an “inflation problem”. Some will point to the weak PMIs earlier this week and the headline slowdown in growth from the GDP report as reasons for downward pressure on market rates. But they are not the drivers. It’s all about inflation.

With the Federal Reserve a tad slavish to upcoming inflation data, the focal point of the curve is the 10-year rather than a stable funds
rate-bullied front end. That makes the curve quite directional, meaning that the shape of the curve is coming from longer tenors. Without a new impulse from the Fed, and with inflation continuing to tick firmer than comfortable, the 10-year Treasury yield is liable to continue to trek towards the 5% area, steepening the curve from the back end. That said, should the Fed surprise us and get ahead of this with some hawkish commentary next week, and even go as far as threatening a hike, then we could see the 10-year yield come off highs on a theory of more Fed inflation protection.

On the back of the higher core PCE deflator that came with US GDP data, the Bund curve shifted higher up to 5bp yesterday with a slight underperformance of the 5-year belly. The 10-year Bund yield is now safely above 2.6% with the spread to US Treasury yields widening slightly to 207bp.

EUR rates had looked more prone to being dragged higher after the recently better survey data and also remarks from the ECB hawks becoming more focused on the rates outlook beyond June. A cut in June seems to be a settled case, but beyond that is more uncertain. The ECB’s Madis Muller, for instance, argued this week against back-to-back cuts, underscoring the more cautionary tone of late.

Market pricing seems to have taken heed with the OIS forwards now showing less than 70bp of easing priced for the year. That still reflects a bias for a base case of three cuts this year, but the position on a third cut is clearly becoming less firm. Markets' longer-run inflation expectations have also started to drift higher since February with the 5y5y inflation forward testing the 2.4% level this week. The level itself is perhaps not that worrying, but the ECB may eye the trend with some concern. Today, we will get the ECB consumer survey on 1Y and 3Y inflation.