Bond Markets: the week ahead

Summary:

• Despite first-quarter GDP growth falling short of expectations, bond markets focus on the persistent core PCE, anticipating a patient stance from the Federal Reserve on rate cuts.
• The Quarterly Refunding Announcement (QRA) this week holds significance, with expectations of lower borrowing needs from the Treasury. However, indications of continued coupon issuance growth, exceeding $1 trillion quarterly, may constrain upside for US Treasuries.
• The FOMC meeting revolves around expectations of rate cuts and QT deceleration amidst inflation concerns. Anticipated intensification of QT tapering discussions reflects policymakers' growing apprehension about the ample reserves in the system, despite inflation showing resilience.
• While a dovish FOMC meeting could trigger a yield decrease, the prevailing upward trajectory of 10-year yields persists, suggesting a potential breach above 4.7% in the weeks ahead.

Key takeaways from last week

In recent weeks, the bond market has been conveying a critical message: inflation reigns supreme over all other economic indicators.

US Treasury yields have surged across the board, reaching levels not seen since November last year. The rationale behind this surge is straightforward: Inflation appears entrenched well above the Federal Reserve's 2% target, hovering around 3% with indications of a potential rebound. Consequently, the Fed may be compelled to maintain interest rates at their current levels for an extended period or, if a second wave of inflation materializes, resume interest rate hikes. Consequently, fixed income investors are demanding a higher premium to hold onto fixed-income securities. This was confirmed at this week's 5- and 7-year US Treasury auctions, which witnessed solid demand, but investors demanded higher yields. This indicates that US Treasuries are still considered a viable diversification tool in one's portfolio, nevertheless at the right price.

Currently standing at 4.6%, the 10-year US Treasury yield reflects the market's expectations of persistent inflation above the Fed's target and sustained economic growth.

Despite a weaker-than-anticipated GDP print for the first quarter, which saw real growth at 1.6% compared to the expected 2.4%, investors have focused on the first quarter's annualized core PCE, which rose to 3.7% versus an expected 3.4%.

Economists were swift to downplay the lower GDP figure, suggesting that once the cyclical components (net exports and inventories) were removed, the annualized GDP for the quarter would still hover around 2.8%. This narrative dispels the notion of an economy teetering on the brink of collapse, painting a picture of a more resilient economic landscape.

The heart of the issue lies within core PCE. Not only does it appear to be stabilizing, but the three- and six-month annualized figures suggest a potential rebound in core PCE, mirroring the intensity of the upward trend witnessed in 2021.