Upward pressure on bond yields

U.S 10 year bond yields are going up

Although last week’s CPI data from the US was only slightly above market expectations at the headline level, and in line in core terms, price pressure continues to rise. The market seems to sense this as well as market-based inflation expectations continue to rise, and not just in the US. The US data does show that some areas of the economy where prices had been rising particularly swiftly, like used car prices, have moderated. But some sectors with far bigger weights in the CPI, like shelter, will take over and produce consistent inflation strength as the surge in house prices and rents slowly starts to filter through. It is not uncommon to see shelter prices respond slowly to house prices and rents; sometime there appears to be very little response at all.

But undoubtedly there is a danger given that house prices are rising at over 17% in annual terms while annual shelter prices are up 2.5%. It is doubted that shelter inflation would rise dramatically but it has such a big weight in the CPI that even a modest rise could entrench annual inflation at target-busting levels. Given this inflation backdrop, Mr. Steve Barrow, Head of Standard Bank G10 Strategy remains biased for yields to rise with 10-year treasuries still gunning for 2% -plus over the next 6-12 months.

The fact that the Bank of England seems to be close to lifting rates, at a time when inflation is considerably below that of the US, might make the market all the more edgy that the Fed is falling behind the curve. The economic trajectories of the UK and US are often quite close. Sometimes differences in inflation performance owe much to movements in the pound and the greater sensitivity of UK inflation to exchange rate movements than we see in the US.

However, right now, the pound has been quite stable; in fact, it has climbed by over 5% in the last year on the BoE’s broad trade-weighted index. It means that there’s actually quite a lot of commonality between UK inflation and that in the US, but it seems that only one of these (the BoE) is prepared to act with higher rates as soon as this year – and even before it has finished its asset purchases. Of course, the Fed can ‘tighten’ itself by tapering its bond purchases and will probably announce next month that it intends to do so. But that might not be enough. In fact, the tapering schedule could hamper an effective policy response because the Fed has signalled that it won’t start to lift rates until the taper is finished.

Given that this is not likely to be until next summer it means that there could be a very nervy period for the Fed and the market over the next six-months-plus should inflationary pressure continue to build. Undoubtedly actual CPI and PCE inflation will drop over this period because some of the very big monthly increases we saw in the first half of 2021 won’t be repeated in 2022. But the key is not whether inflation falls; it is whether it falls at a pace that gives the Fed a realistic chance of meeting its inflation target without having to pull forward rate hikes.

“We are not sure that inflation will fall as much as the Fed expects and we think the fact that the BoE might have decided to act quickly on rates just puts more pressure on the Fed. At worst it could make for a very difficult situation for the Fed and financial markets in general next year should a rise in policy rates appear to be desperately necessary but the bank remains reticent to lift rates while still buying bonds at the same time. We certainly think it is dangerous for a bank to put itself in a position where it seemingly rules out the possibility of higher rates for a specific period of time. Should inflation prove persistent and the Fed unwilling to hike in the first half of 2022 we could see the yield curve steepen materially”, Mr. Steve Barrow said and added that for most other major central banks, such as the ECB and BoJ, the possibility of swift action to counter price pressures seems limit ed. Inflation is close to target in the euro zone but our sense is still that this is primarily a function of higher oil prices, while price pressure in the US seems broader based. Japan’s inflation is arguably higher than the data suggests given the temporary distortion earlier this year of sharp reduction in phone charges. But even one this is put back in the BoJ still remains well short of its inflation target and, like the ECB, rate hikes still seem to be in the dim and distant future.