Rates Spark: Data does the talking

Yield curves are in bull steepening mode. While underlying risk sentiment was dampened by softer Chinese data, it was the first European inflation readings that provided the push lower in the European session. Notably it was sterling rates that outperformed, but we attribute that to its generally higher beta and, as we highlighted before, that it displayed the highest discrepancy between market levels and central bank messaging to begin with. But also in the eurozone the market is now no longer fully discounting two more 25bp hikes from the European Central Bank.

Inflation data will be subject to more noise given government interventions

The releases itself, German and then French preliminary country data, showed headline inflation dropping faster than anticipated. Our economist sees signs of broadening disinflationary trends, but also cautions that inflation data will be subject to more statistical noise given government interventions such as the newly introduced €49 monthly train tickets in Germany, which pushed inflation down in May.

Some ECB officials have also reacted with cautious optimism to the inflation data. France’s Villeroy noted that we will probably have seen the peak in French inflation now with the monetary policy tightening also starting to show its effect. In his view it was a sign that “rather than the level of the terminal rate […], it’s how long we remain there that is essential”. The ECB’s hawks, who had been more vocal in recent weeks, might still question whether the tightening delivered so far is sufficient. Looking at market-based expectations of inflation they could point to 5y5y inflation swap forwards, while falling again is still sitting above 2.5%. And despite encouraging developments in the headline, it is the underlying dynamics of core inflation that remains key.

The US session saw more volatility around a mixed bag of data releases. Regional PMIs were weaker while data on job openings came in stronger than expected. More interesting – and with larger effect on front end pricing – were comments from two key Federal Open Market Committee voting members. Fed Governor Jefferson and Philadelphia Fed President Harker both made the case for skipping the June FOMC meeting. After all, the anecdotal evidence provided in the Fed’s Beige book released yesterday showed hints of a cooling job market and also more signs of disinflationary dynamics gaining traction.

Strong jobs and inflation data can still mean a hike in June

The Fed funds forward for the June meeting period dropped by some 8bp to below 10bp in the wake of the comments. The forward for July, marking the high point in the forwards, ie, terminal rate, also dropped 5bp with 21bp hikes now discounted. Markets, and in the end also the Fed, will be looking to the key data ahead, such as the payrolls report due tomorrow and the next CPI report. Strong readings here would still make the case for a June hike.