The calm before a potential storm

As we await inflation figures that are likely to have a major impact on US monetary policy, dollar-denominated bonds are presenting stable yields at the end of a quiet week. Near 4.5%, the yield on the 10-year T-Note is not immune to a sharp rebound if inflation once again proves to be more protracted than forecast by a consensus that is still counting on a gradual decline in “core” inflation. Conversely, a contained rise in consumer prices would strengthen hopes of an initial cut in the Fed funds rate in September and a subsequent decline in money market rates below 5% by the end of the year.

The few indicators published last week highlighted a deterioration in consumer confidence. The University of Michigan index fell by a significant 10 points in May (67.5 in the first estimate, after 77.2 in April). This breakdown, after three months of stability, is the result of an unfavourable perception of inflation, the labour market and interest rates, which should hamper real household spending.

Household inflation expectations, which are unreliable and influenced by recent trends in fuel and food prices, have continued to drift upwards, reaching 3.1% (p.a.) over a five-year horizon. However, this prediction is contradicted by the decline in ‘breakeven’ rates, which establish an equivalence between the yield on inflation-indexed TIPS and traditional Treasury bonds. The Fed has therefore not lost its credibility in the eyes of investors, who continue to hope for a “soft landing” in the USA. With this in mind, the S&P 500 index has returned very close to its all-time high reached at the end of March, and could easily surpass it if inflation continues to fall on Wednesday. In line with equities, credit risk premia have fallen back close to the levels seen before the episode of tension in April.

In Europe, the euro capital market was flat. The yield on the 10-year German Bund is stable at around 2.5% and the structure of interest rates has not changed in the run-up to the first rate cut, which is still expected on 6 June. As in the US, there has been no major news to agitate the ECB or investors.

Outside the eurozone, the Bank of England maintained its key interest rate at 5.25%, while hinting at the possibility of a reduction in the near future, perhaps as early as 20 June. Two of the nine members of the committee were in favour of a rate cut, but a large majority voted to wait until inflation eases further, after having fallen from 11% in October 2022 to 3.2% last month. The tone of the statement and Governor Bailey’s friendly comments pushed sterling yields down, despite the fact that the UK economy returned to positive growth in the first quarter of 2024. Against the global trend, Swiss franc yields edged up.