While the US yield curve was undergoing a massive flattening, breakeven rates were dropping too. That’s quite an understandable move because if the central bank is planning to pull stimulus from the system, inflation is expected to subside as well. Yet, the correction was quite abrupt, with 5-year Breakevens falling to 2.37%, roughly 40bps down from their peak in May. The 5-year 5-year forward plunged to 2.11%, a drop of 30bps from a month ago. We believe that with the breakevens adjusting so suddenly and long-term yields falling too, the bond market is telling us that the Federal Reserve may not be able to keep up with their tightening cycle as growth may lag and inflation should normalize, forcing the central back into a new era of accommodative measures.
Yet, that is a dangerous position to take because there are no signs that inflationary pressures are transitory. While commodities might have peaked, there are still many core price pressures that might have not. Additionally, nothing is telling us that the Federal Reserve will be able to control inflation. Thus, the whole yield curve remains at risk until the transitory nature of consumer prices isn't sure.
Yet, in the immediate future, we can expect the front part of the yield curve to be much more sensitive to inflation expectations and tapering talks. That’s why if Thursday’s PCE index surprises on the upside, we might see short-term yields shifting even higher while long-term yields will stay stable. Ahead of inflation data, we will have the US Treasury issuing 2-, 5- and 7-year Treasuries starting from tomorrow. These maturities are highly vulnerable in light of the recent reversal of monetary policies and short-term inflation expectations. If bidding metrics are week, we could see a further flattening of the yield curve, pushing both the 5s20s and 2s10s spreads to test support at 100bps.
Suppose the yield of 2-year US Treasury bonds rises amid weak demand at tomorrow's auction. In that case, it may be a signal that the market is expecting earlier interest rate hikes than 2022. Last week, 2-year yields rose to 0.27% and stabilized at 0.25% for the first time since April 2020, the high end of the Federal Reserve target fund rate.