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The March inflation print marked the third month in a row that prices pressures surprised on the upside, triggering a spike in US yields across the curve. Headline and core CPI both came in at 0.4% MoM (higher than consensus of 0.3%). Shelter and gas prices were the two main culprits behind the elevated inflation print. However, we note that the other categories including apparel, medical care and transportation services also saw meaningful price increases, indicating that inflation is broad-based.
The difference with prevailing inflation and what was seen in 2022 is that it is taking place under favourable supply side conditions, ensuring a cap on potential upside risks going forward. However, clear signs of a high-pressure economy, characterised by strong growth and sticky inflation, is going to make it rather difficult for the Fed to (i) express comfort with the inflation trend and (ii) embark on a rate cut cycle any time soon. Our longstanding call has been rate cuts only in 2H24. That call remains intact, although the type of rate cuts plausible under the prevailing macro scenario is now mired in uncertainty.
USD rates, which have risen significantly since the start of the year, were still unprepared for this inflation print. Fed cut bets were aggressively pared as the market sees less than two cuts for this year (the Fed’s dotplot indicated three cuts). Further out the curve, yields rose as inflation breakevens got re-priced higher. 10Y breakevens are now above 2.40%, levels not seen since early November. However, worries of stagflation and the risk-off sentiment capped a lid on long-end yields.
The soft-landing base case is now challenged as recent data point to relatively hot economic conditions (resilient growth and sticky inflation). Against this backdrop, it is plausible to argue that the Fed may not need to cut this year. Clearly, data dependence has a big role to play but it would seem that the market has consistently been too hasty in anticipating Fed cuts this cycle. Current market conditions closely resemble that of October 2023 when the entire curve was close to or above 5%. We reiterate significant upside risks (less cuts) to our Fed call through 2025.
In level terms, 10Y yields have gone above our forecast of 4.50% for the quarter and is probably a decent level for real money accounts. Meanwhile, we think 2Y US Treasuries have repriced appropriately (2Y yields at 4.97%) and think yield upside may be limited from this point on.
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