Rates: Worried about stubborn inflation

So far in 2024, the rate cut narrative has been battered by a selection of events. These include a 353k non-farm payrolls outcome, a core inflation reading of 0.4% month-on-month, and even a nudge up in some eurozone confidence indicators. They have been interlaced by survey evidence pointing to pockets of weakness, and we do believe there is a material slowdown brewing, but the big hitting data is still not where it needs to be to make an imminent rate cut a no-brainer.

As a result, market rates are under rising pressure as the carrot of imminent rate cuts remains frustratingly out of immediate reach. The Euribor 10yr almost touched 4% last week, while the US 10yr Treasury yield briefly topped 4.3%. These levels are up from where they were, but in fact, don’t look particularly high when we consider US core consumer price inflation (CPI) running at 3.9% and core eurozone CPI at 3.3%. These are still well above the desired 2% area, and proving a tad stubborn.

Based off market yields versus delivered inflation, real rates are, in consequence, very low. Just 40bp in the US (10yr) and 70bp for the eurozone. Based on this stand-alone metric, there is room for US yields to rise relative to eurozone rates. A theoretical fair value 10yr real rate for the US would be in the 1.5% to 2% area. Adding a 2% to 2.5% inflation expectation on to that would deliver a fair value 10yr yield of 3.5% to 4.5%. Adding a 50bp term premium would see approximately 4% as a neutral 10yr yield.

However, that’s based off an inflation expectation of around 2%, whereas actual inflation (core CPI) is closer to 4%. If core inflation were to remain at around 4%, it must then place upward pressure on Treasury yields. That’s the issue that markets are dealing with currently. The 10yr breakeven inflation rate as backed out from the difference between real yields and nominal yields is 2.3%, based off a market real yield of around 2%. That needs to be justified by falls in delivered inflation, and we’re still waiting.

There is a similar dynamic ongoing in the eurozone. The 10yr market breakeven inflation rate is around 2.2%, yet core CPI inflation is running at over 3%. Therein lies pressure for nominal market rates to rise. To prevent that from happening, realised inflation needs to start to move much closer to the implied market rates. We think that will happen, which ultimately results in a resumed rate cut alert mode, and drives market yields back down.