The recent surge in U.S. real yields reflects the Fed's perception of upside risks to economic growth. This resilience gives the central bank more leeway to tighten financial conditions and address inflation without fearing an immediate recession, representing a key shift in its policy calculus from earlier in the year.
The August Core CPI report appeared hotter than consensus, but this was largely due to a methodology change in the telecommunication services category that added volatility. Excluding this single category's outsized 10 basis point contribution would have brought the core reading below consensus, suggesting a more benign underlying inflation trend.
While surging oil prices pose an inflation risk, their impact on inflation-linked securities may be capped. Extreme commodity price hikes can harm broader risk sentiment. Since inflation break-evens often trade like risk assets within the bond market, a negative shift in investor sentiment could actually cause them to trade lower.
The Fed's primary inflation gauge, Core PCE, is running nearly 100 basis points hotter than Core CPI, the benchmark for inflation markets. This creates a risk of the Fed overtightening policy based on sticky PCE data, which could lead to a weaker-than-expected inflation outcome for CPI and thus cause underperformance for CPI-linked bonds.
While short-term Eurozone inflation has been volatile due to energy prices and geopolitics, long-term inflation expectations (5-year, 5-year forwards) have remained remarkably stable. This signals strong market confidence in the European Central Bank's credibility and its ability to return inflation to its target over the medium term.
The historically positive relationship between UK short-term inflation (RPI) and rate expectations (Sonia) has recently broken down. One-year, one-year RPI has fallen even as Sonia has rallied, suggesting other factors are now more dominant. This decoupling has left front-end inflation looking cheap relative to rates, presenting a potential tactical opportunity.