While the US economy struggles to recover jobs, commodity prices continue to surge, with the Bloomberg Commodity Index hitting a new high level in years almost every day. Last week, breakeven rates rose to new high levels, with the 10-year Breakeven breaking above 2.5% for the first time since 2012 while the 5-year Breakeven rate rose to 2.70%, the highest since 2008.
The market starts to accept the core message of the Average Inflation Targeting (AIT) framework: despite inflationary pressures continue to strengthen, the Fed will remain impassively dovish. Within this context, bond vigilante might soon start to dump US Treasuries as the risk of a Fed’s monetary policy mistake is rising together with inflation expectations.
Therefore we believe it is necessary to watch out for catalysts that may renew a selloff in US Treasuries. One of them could come as soon as this Wednesday if monthly CPI data comes stronger than forecasted. The market is expecting a 3.6% YoY rise of CPI, the highest since 2011. However, the monthly CPI reading will be more critical because while yearly inflation following the pandemic will be transitory, the monthly may not be.
The 3-, 10- and 30-year Treasury auctions between Tuesday and Thursday will also be important. Our attention is focused on bidding metrics and foreign demand in particular, which is lagging since the beginning of the year.
Are European sovereign yields in check?
In Europe, the focus continues to grow around June’s ECB monetary policy meeting. Today, the central bank's Chief Economist Philip Lane said that the PEPP program could be adjusted in June. He hints at the fact that it may be extended because the economy will most likely require monetary support. Also critical is the recent comment made by the governor of Finland's central bank, Olli Rehn, who said that the ECB should adopt the Fed's AIG framework. Both comments highlight the inclination of the ECB members to provide the central bank with more flexibility to continue purchasing European bonds amid the economic recovery. However, we believe that increased dovishness will not keep in check European sovereign yields because EU government bonds remain tightly correlated to US Treasuries. Therefore, until the german election, European yields will remain vulnerable to changes in US yields. Once US Treasury yields resume rising, we might see a rotation from EU Sovereign to the US safe-haven materializing. Yet, the German election will ultimately push yields higher, provoking Bund yields to turn positive. In the short-term, Bund yields could break below the lower uptrend line of the ascending wedge they have been trading in since March and find new support at -0.40%. However, if they break above -0.15%, they could rise fast to 0%.