Rates Spark: Are we there yet?

There was something in the air in the past few trading days. Just when 4% on the 10yr was looking comfortable, there was a pivot of attention towards yesterday's CPI report. Consensus pointed to a low 3% headline number. But we got better. Bang on 3%, so close to a break into a 2% handle. And, the core rate gets back below 5% for the first time in a year and a half. A good look for inflation overall, and correlating with market rates heading decisively lower.

The 10Y US Treasury is now below 3.9% and the 2Y closer to 4.70%. The curve dis-inverted, this time in bull-steeping fashion as one would expect towards the end of a tightening cycle. Both real yields and inflation expectations ease lower. The 2Y breakeven rate has dipped back below 2%, a very comforting reading from the Fed’s perspective.

The question now is whether the market continues to trade off the easing inflation narrative. There is an excuse to do so as today’s PPI report is also expected to be friendly. It’s quite a swing from the strong wage data last week into an easing inflation narrative for this week. Both are in fact backward looking, but the core inflation reading in particular is the dominant driver for market rates. If the market begins to believe that easing pipeline pressures and the pull of lower headline rates can dominate, then the strong labour market backdrop can be downsized as an issue.

It is tough to make a conviction-directional view from here. We had been consistently looking for a break above 4% and to stay above that level for a while. But we are clearly back below, and with some reasonable justification.

The European Central Bank will release the minutes of the June policy meeting. Recall that the ECB hiked rates by 25bp and all but pre-announced another 25bp hike for this month. Markets have more than complied and are now more than fully discounting one more hike by the end of the year.

This contrasts with more signs that inflation pressure is actually starting to ease, not just in the US but also in the eurozone. But it also suggests markets are for now still fully embracing the ECB’s focus on current inflation and it basing the policy stance on backward-looking data – a clear preference to err on the side of doing too much when it comes to inflation.

But there have also been important voices within the ECB’s governing council which seem to take a more centrist view. The Bank of France’s Francois Villeroy recently acknowledged that there was “first good news” on inflation and that policy rates would soon reach their terminal rate. ECB observers will scour today’s minutes to see whether the hawkish consensus is starting to crack in light of the softer macro backdrop. After all, we also believe that the ECB’s own growth forecasts on which the hawkish case is based look overly optimistic.