Rates Spark: A path to 4.5%

As we roll towards the March payrolls report (to be released on Friday), there is a practical acceptance that the number will be decent. Wednesday’s ADP employment report was firm, and the momentum so far in 2024 is matching that of the second half of 2023. On top of that, the CPI report due next week is showing market expectations of 0.3% and 0.4% month-on-month, which if confirmed would suggest that the US is not a 3% inflation economy but is in fact closer to being a 4% one.

These inflation data are not only slashing expectations for the number of cuts in 2024, they are also ratcheting higher the market estimate for the terminal funds rate. Now that’s in the area of 4%, or more correctly in the 3.75% to 4% area. This is an important line in the sand, as it effectively represents a floor for market rates. More succinctly, longer dated market rates really have no business going below 4% for as long as that discount for the funds rate is in place.

So, when we look at the 10yr yield at 4.35%, it’s not particularly elevated, when viewed relative to the notional 4% floor as described. The 10yr should in fact trade with a positive term premium, and thus trade comfortably above such a floor. As we look forward, it’s tough to argue that 10yr Treasuries are a glaring buy. Sure, they are cheaper than they were at the beginning of the year. But the question is can they get cheaper. And the answer is still yes. If we get a firm payrolls report on Friday, and the discount for another pop in CPI hardens into next week, then the conversation revolves around heading to the 4.5% area.

This all still contrasts with developments in EUR rates where Wednesday’s data showed inflation cooling faster than forecast – both headline and core inflation are now back at a 2% handle – even if only barely so for core. Conviction for a June cut remains strong, with pricing for overall easing this year still closer to 90bp even as EUR rates are also feeling some spillover from the US.

The divergence is nicely illustrated by the 10Y UST-Bund spread, which briefly moved above 200bp on Wednesday. This level was last breached for a short period in autumn last year when markets felt pressure from rising Treasury supply prospects, however, it has basically been a cap throughout the pandemic years. The last structural move beyond that level was when Fed and ECB policies started to materially diverge from 2017 onwards.