Bonds Might Look Appealing, But Only For Now

Authored by Simon White, Bloomberg macro strategist,

US bonds are rallying with core inflation that shows clear signs of decelerating. That is likely to continue in the medium term, but the longer-term picture is one of rising yields in the context of historically elevated inflation.

After touching a high of 4.09% in recent days, the 10-year yield is lower by over 20 bps, at around 3.82%. The trigger was Wednesday’s core CPI, which came in lower than expected. That trend should continue over the next three-six months.

Inflation leading indicators continue to point downwards, showing headline inflation should keep falling for now. Fixing swaps also anticipate a continued steady drop in headline over the next six-nine months.

Core’s fall is now being driven by the shelter component - accounting for a significant ~43% of the core basket - and that should also keep declining as rental vacancy rates rise.

Now that it is clear core as well as headline inflation’s downwards momentum is rising, the Federal Reserve can afford to take its foot off the brake, as falling inflation naturally tightens real rates (a July hike looks baked in, but it’s probably only necessary now so as not to upset forward-rate pricing).

This is a global phenomenon. Expectations are central banks will become less hawkish, leading to the Advanced Global Financial Tightness Indicator rising, i.e. financial conditions are becoming less tight – and this points to lower US 10-year yields.

But this should be viewed as a trade, not an investment. Inflation is likely to re-accelerate again.

The US labor market is structurally very tight, higher profit margins are becoming entrenched and, sooner more likely than later, easing in China will break through.

The bulk of disinflation seen thus far has been driven by China. But we are nearing the limits of what the nation can tolerate in terms of tepid growth and rising unemployment. The turn in China would mean a re-acceleration in global inflation as soon as year-end.

Term premium has been remarkably subdued in this cycle despite near double-digit price growth. But a volte-face in inflation right at the moment most think it’s been pacified would likely lead to a structural rise in longer-term yields as holders demand extra compensation. You don’t want to get caught on the wrong side of that.