The bond weekly wrap: slower than expected disinflation creates a floor for bond yields.

The bond weekly wrap: slower than expected disinflation creates a floor for bond yields.

Bonds
Althea Spinozzi

Head of Fixed Income Strategy

Summary:  The latest data on core and headline PCE in the US met expectations, but the six-month annualized data increased to 2.5% and 3.1%, respectively, up from 1.9% and 2.5% in the previous month. In Europe, core and headline CPI dropped at a slower pace than what economists had predicted. These movements are likely to set a floor for bond yields as central banks will become more cautious in reducing interest rates in the near future. As a result, government bond yields on both sides of the Atlantic are expected to remain rangebound until the macroeconomic outlook becomes more evident.


The highlight of the week has been inflation, with the PCE deflator meeting expectations, rising +0.3% monthly and 2.4% YoY, the lowest since February 2021. However, the core PCE remains sticky, running at 0.42% MoM. The problem with this report is that while core PCE was running at 1.9% on a six-month annual basis the month before, after this week's report, it rose to 2.5%. Also, headline PCE rose from 3.1% to 2.5% on a six-month annualized basis, showing that the disinflation story might be losing steam.

In the meantime, inflation expectations are rising. The 2-year US breakeven rate rose near 2.5%, the highest since March 2023, while the 5-year US breakeven rate rose to 2.78%, the highest since March 2023. Breakeven rates are calculated as the spread between nominal bond yields and inflation-linked bond yields and represent market expectations on inflation in a few years. Inflation expectations are important because they influence decisions about consumption and investment. For example, if corporations expect inflation to be higher in two years, they would spend today, fueling inflation further. Rising breakeven rates are bearish for bonds and create a floor for US Treasury yields.

Source: Bloomberg.

In Europe, headline and core inflation continue to fall, but slower than economists expected. There are signs that the 3-month and 6-month annualized headline and core inflation have bottomed, building the case for less aggressive rate cuts by the ECB. However, the recent drop in CPI will enable the ECB to revise the staff inflation projections for this year downward at next week's ECB monetary policy meeting, giving a modest boost to European sovereign bonds, as illustrated in our ECB preview.

However, interest rates will likely trade rangebound until the macroeconomic picture and disinflationary trends become clearer.

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