Rates Spark: The evaporation of real yields

Headline US producer price inflation has hit 6%, and headline US consumer price inflation is approaching 4%. Both of these readings are for April. By the May readings, they'll be higher still. The US economy will become a base "4% inflation economy." While the expectation is for inflation to rise into the summer, but then to ease through the fall, we still have to acknowledge the importance of current printed inflation rates. It's the latest delivered inflation. No ifs or buts or forecasts, it's simply there.

The level of rates needs to be confronted against the elevated inflation rates that we have right now. The 10yr SOFR is now above 4%, approaching 4.05%. That's quite close to where printed CPI inflation is, meaning a puny implied real yield. Until inflation actually falls, this remains a relative value negative for rates. A low real yield means holders are barely keeping pace with inflation. Not good for Treasuries.

Meanwhile, the Fed pitches the effective funds rate at 3.64% currently. That's below headline inflation. Kevin Warsh was finally confirmed by the Senate as the new Fed Chair, but has no chance to cut rates against the current inflation environment, at least not any time soon. In fact, the dominant market discount attaches a greater probability to a hike than a cut as the next move. Also not good for Treasuries, as it pivots the front of the curve higher, placing relative value pressure on higher long tenor rates too.

Similar in the eurozone, but even more stark. The ECB has the deposit rate at 2%, yet headline inflation is running at 3%. That's a negative real depo rate to the tune of 1%; crude as measured off the latest print. But accurate for the same reason. Plus, inflation remains under rising pressure. Then we look at the 10yr rate. Take your pick; the 10yr Bund yield or the 10yr EURIBOR rate, both are above 3%. That's broadly flat to the headline inflation environment, and so a zero or very low real rate is in play in the 10yr. This pressures rates to remain elevated from a real rates perspective, and risk of the build of a cushion over inflation grows every day the Strait remains closed.

Overall, we await outcomes from China, on the summit with the US. We also await the next moves on the Iran war front, which likely comes after our China wait. And we wait for the elevated oil price to continue to filter into printed inflation. All the while, the logic for elevated yields, and especially longer-term ones remains in place. We likely get an overshoot before we calm, but we're still on that overshoot uplift, which could well last a few more weeks. Or we get there much faster, and in a more disorderly manner (risk case). By mid-year, market rates likely have calmed. It's the in-between period that concerns us.