Rates Spark: On the verge of breakouts

Since the US attack on Iran commenced, we have been quite impressed with the rise in the 2yr real yield. It effectively rose from 55bp to over 65bp. Because the 2yr nominal rate rose by 10bp more than this, 2yr break-even inflation rose from 2.8% to 2.9%. So, the narrative up until Thursday was one of an elevation in inflation expectations alongside a rise in the real yield, and we could reverse engineer a rationale that the market was discounting more inflation but not worried about a material hit to real growth.

Well, that narrative changed on Thursday, as the 2yr real yield fell back down to sub 60bp, in what was quite a precipitous move. That in turn facilitated a further rise in the 2yr break-even inflation rate to 3%, augmented by a rise in the nominal 2yr yield (so the break-even rate was being pulled from both ends). While we don't want to read too much into this, one clear implication is the market is getting a little more concerned about negative activity effects stemming from the conflict in the Middle East.

This coincided with a poor day on equity markets; a dominant risk-off tone. That fits with the notion of a larger negative hit on activity than had been discounted through most of the week to date

That all being said, there are different impulses in play in longer tenors. In the 10yr, the dominant outcome has been a rise in the real yield, from 1.7% to 1.8%. That broadly matches the rise in the nominal yield, meaning that the break-even inflation rate has remained broadly unchanged in the 2.3% area. Here the narrative is one of no long-lasting inflation effect, and no material negative hit to medium-term growth circumstances.

What to make of all of this? Well, the front end is now winding up a discount for some growth angst alongside an elevation in inflation. The back end remains non-committal, but what is interesting is the steepening of the 2/10yr real curve relative to a flattening in the 2/10yr nominal curve. The 2/10yr real curve is now out to over 120bp, relative to the nominal 2/10yr curve at around 55bp. No rocket science here, as the difference between the two curves is broadly equal to the difference between 2yr and 10yr break-even inflation (3% vs 2.3%).

But if something gives here, it's likely that the nominal 2/10yr curve is too flat and the 10yr break-even inflation rate too low. Prepare for a breakout on both in the weeks ahead.

Markets are back to pricing in more than a 50% chance of a European Central Bank rate hike in 2026 alongside the move higher in energy prices. Money market curves are even eyeing a 15% chance of a rate hike by April. That seems far-fetched given current energy prices but does highlight that markets are not neglecting tail risks where oil and gas push a lot higher. This is also reflected in another move higher in implied rate volatilities, suggesting more uncertainty ahead of us.

The initial reaction on Monday to the escalation over the weekend seemed in line with a relatively short-lived conflict and not one with a prolonged market impact, but this can change over time. One could have argued that risk sentiment so far held alright and that the rise in oil prices is still contained. As the days go on, however, the probability of a more prolonged market impact naturally rises alongside. That means that no news is bad news. That also means that 2Y swap rates can keep rising.