Head of Fixed Income Strategy
Financial market participants eagerly await this week's US core PCE data, hoping for signs of moderation. However, recent developments in Canada and Australia remind us that one lower inflation reading doesn't establish a trend, prompting central banks to stay alert about inflation and potentially delay interest rate cuts as long as the economy doesn’t show significant signs of slowing down.
In Canada, headline inflation surged unexpectedly to 2.9% in May while consensus was expecting it to drop to 2.6% from 2.7% in April, challenging expectations for a rate cut next month. Trimmed and median core inflation also ticked higher ending a four-month streak of lower readings. The only measure to continue to decrease was core common CPI, suggesting that while inflation is increasing broadly, the most significant price increases come from certain stable categories captured by the trimmed and median CPIs, but not but the common CPI. The latest data makes it unlikely for the Bank of Canada to cut rates next month.
In Australia, headline inflation increased for the third straight month since February, with the core reading tilting up from 3.5% in April and March to 3.7% in May. Last week, the Reserve Bank of Australia indicated it would take necessary measures to control inflation, including potential rate hikes. The latest inflation data strengthens the likelihood of further tightening in the upcoming meetings.
In the US, traders expect the core PCE to decrease to 2.6% in May from 2.8% in April. While this forecast seems reliable based on existing data, it shouldn't create expectations for more policy easing than currently projected. Core PCE has been steadily declining each month since January 2023, but at a slower pace recently. Bond markets are pricing in 44 basis points of rate cuts by December this year. However, recent comments from Federal Reserve officials indicate that the central bank remains data-dependent and may not cut rates unless the economy shows more significant signs of cooling.
While preliminary CPI data for the Eurozone will be available next week, the focus this week will be on the 1- and 3-year Eurozone CPI expectations. These inflation expectations are crucial because they influence consumer and business behavior. If inflation is perceived to remain high, it could trigger a feedback loop, increasing inflation pressures as workers and unions demand higher wages.
The 1-year Eurozone CPI expected rate has dropped for three consecutive months and is projected to have decreased further to 2.8% in May. In contrast, the 3-year CPI expected rate has been fluctuating between 2.4% and 2.5% since November, and it is expected to have remained steady at 2.5% in May. If the data meet expectations, it's unlikely that a favorable CPI figure next week will boost expectations for further interest rate cuts.
Markets are currently pricing in another 46 basis points of rate cuts by the ECB by December, following the rate cut in June. However, with inflation still above the ECB's 2% target and having rebounded slightly in May, it's unlikely that policymakers will signal a willingness to cut more than what is currently priced in. This is especially true with the Federal Reserve on hold and a weak euro.
The economy's "neutral rate" (the borrowing cost level that neither stimulates nor slows growth) is now believed to be higher than previously thought. A higher neutral rate suggests fewer rate cuts and higher interest rates over the next decade compared to the past ten years.
The bond futures market expects policy rates to bottom out at 3.6% in 2027 before rising again, which is about 85 basis points higher than what currently forecasted in the Fed’s dot plot. This higher neutral rate sets a floor for yields across tenors, meaning they are unlikely to drop much lower than the expected neutral rate. As the yield curve normalizes, 10-year yields are expected to be around 100-150 basis points above the Fed's fund rate. Assuming a long-term neutral fund rate of 3.6%, the fair value of US Treasury yields should be between 4.6% and 5.1%.
Therefore, further bond gains depend on the upcoming Fed’s interest rate cutting cycle, which may be limited unless there is a significant slowdown in inflation and growth. This is why, despite expectations of rate cuts this year, long-term bond yields in Canada, Australia, and the US have all risen.
30-May ECB preview: One alone is like none at all.
28-May Insights into this week's US Treasury auctions: 2-, 5-, and 7-year tenors overview.
22-May UK April’s Consumer Prices: Markets Abandon Hopes for a Linear Disinflation Path.
17-May Strong trade-weighted EUR gives ECB green light to cut rates, but bond bull rally unlikely
14-May UK labor data and Huw Pill's comments are not enough for a bond bull rally
08-May Bank of England preview: Rate cuts in mind, but patience required.
06-May Insights into this week's US Treasury refunding: 3-, 10-, and 30-year overview
02-May FOMC Meeting Takeaways: Why Inflation Risk Might Come to Bite the Fed
30-Apr FOMC preview: challenging the March dot plot.
29-Apr Bond Markets: the week ahead
25-Apr A tactical guide to the upcoming quarterly refunding announcement for bond and stock markets
22-Apr Analyzing market impacts: insights into the upcoming 5-year and 7-year US Treasury auctions.
18-Apr Italian BTPs are more attractive than German Schatz in today's macroeconomic context
16-Apr QT Tapering Looms Despite Macroeconomic Conditions: Fear of Liquidity Squeeze Drives Policy
08-Apr ECB preview: data-driven until June, Fed-dependent thereafter.
03-Apr Fixed income: Keep calm, seize the moment.
21-Mar FOMC bond takeaway: beware of ultra-long duration.
18-Mar Bank of England Preview: slight dovish shift in the MPC amid disinflationary trends.
18-Mar FOMC Preview: dot plot and quantitative tightening in focus.
12-Mar US Treasury auctions on the back of the US CPI might offer critical insights to investors.
07-Mar The Debt Management Office's Gilts Sales Matter More Than The Spring Budget.
05-Mar "Quantitative Tightening" or "Operation Twist" is coming up. What are the implications for bonds?
01-Mar The bond weekly wrap: slower than expected disinflation creates a floor for bond yields.
29-Feb ECB preview: European sovereign bond yields are likely to remain rangebound until the first rate cut.
27-Feb Defense bonds: risks and opportunities amid an uncertain geopolitical and macroeconomic environment.
23-Feb Two-year US Treasury notes offer an appealing entry point.
21-Feb Four reasons why the ECB keeps calm and cuts later.
14 Feb Higher CPI shows that rates volatility will remain elevated.
12 Feb Ultra-long sovereign issuance draws buy-the-dip demand but stakes are high.
06 Feb Technical Update - US 10-year Treasury yields resuming uptrend? US Treasury and Euro Bund futures testing key supports
05 Feb The upcoming 30-year US Treasury auction might rattle markets
30 Jan BOE preview: BoE hold unlikely to last as inflation plummets
29 Jan FOMC preview: the Fed might be on hold, but easing is inevitable.
26 Jan The ECB holds rates: is the bond rally sustainable?
18 Jan The most infamous bond trade: the Austria century bond.
16 Jan European sovereigns: inflation, stagnation and the bumpy road to rate cuts in 2024.
10 Jan US Treasuries: where do we go from here?
09 Jan Quarterly Outlook: bonds on everybody’s lips.
2024: The wasted year
Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
