Rates Spark: Back To A 5% 10Y UST On Inflation Fears

(MENAFN- ING) Impact from hot US inflation was amplified by Fed comments

An unpleasant US inflation surprise for rates, taking the 10Y UST yield right back to 5%, is a justified move in our view. A core CPI reading of 0.3% MoM annualises to a yearly inflation number well above 3% and far from the Fed's target. Add additional uncertainty from energy prices and AI investments, and markets are right to be nervous. Last week's solid payrolls report also gives little reason for the Fed to choose a more dovish path for now.

Following on from Fed Governor Chris Waller's comment that he backs a 25bp hike in December and could opt for a 50bp hike, Treasury yields pushed even higher, with the 10yr up 6bp and 2yr up 13bp since before Waller's comments. Markets are now more than fully pricing in a 25bp hike in December, in line with our own forecast, versus 20bp from before Waller's comments.

Nonetheless, the hopes of a Middle East de-escalation are pulling energy costs lower, with retail gasoline prices now below $4/gallon for the first time since mid-July. This will certainly help give a subdued November inflation print, but we won't get that until the day after the December FOMC meeting. The Fed may get a sneak peek, and that should give it the confidence to only raise rates by 25bp. We are not forecasting any further hikes in 2027 as interest rate-sensitive sectors cool further, with housing costs and lower energy prices, amidst weak wage growth, dampening price pressures in the economy.

European rates shouldn't follow hawkish US repricing blindly

Euro and sterling rates quickly followed the Fed's hawkish repricing, but we think those moves could fade fast. Interestingly, the 2Y EUR inflation swap fell on the day, suggesting the spillovers were purely in real terms. In other words, markets are quick to translate tighter Fed policy into tighter ECB policy. But the reality is more complex. Both regions face very different inflation paths, whereby Europe is more exposed to energy prices and the US to AI-related growth. A tight correlation between US and European rates is warranted if driven by oil as the common denominator, but less so if triggered by macro data.

In addition, higher US rates imply tighter financial conditions for Europe, which means the ECB or Bank of England may not need to act as aggressively as currently priced. Many ECB speakers have indeed made the link between higher longer-dated interest rates and the reduced need to increase policy rates. In other words, markets are already doing the tightening. We therefore prefer to focus on European inflation data and not get carried away by US CPI surprises.

Wednesday's events and market views

A relatively light data calendar. A US holiday also means trading could be quiet. More interesting might be the various ECB speakers lined up, including Cipollone, Kazaks, Nagel and Lagarde.

The UK will sell £1bn of Gilts, while Germany will auction €2.50bn in total across 30y and 21y Bunds.

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