Bond Market Update: Canada and Australia Inflation Data Dampen Disinflation Hopes. Bond Market Update: Canada and Australia Inflation Data Dampen Disinflation Hopes. Bond Market Update: Canada and Australia Inflation Data Dampen Disinflation Hopes.

Bond Market Update: Canada and Australia Inflation Data Dampen Disinflation Hopes.

Bonds
Althea Spinozzi

Head of Fixed Income Strategy

Summary:

  • Recent inflation data from Canada and Australia show that lower inflation readings do not establish a trend, highlighting the persistence of inflation pressures.
  • In the US, core PCE is expected to decrease to 2.6% in May, but this shouldn’t create expectations for more policy easing. The Fed remains data-dependent and may not cut rates unless there are clear signs of economic cooling.
  • Eurozone inflation expectations are in focus this week, with the 1-year CPI rate expected to drop to 2.8% and the 3-year rate holding steady at 2.5%. Given these projections, it is unlikely that markets will anticipate more aggressive rate cuts this year, even if next week's preliminary inflation data surprises on the downside.
  • Aggressive interest rate cuts by central banks are essential for a bond rally. Without them, while the yield curve may continue to normalize, a higher long-term neutral rate will set a floor, preventing yields across tenors from dropping significantly.

Financial market participants eagerly await this week's US core PCE data, hoping for signs of moderation. However, recent developments in Canada and Australia remind us that one lower inflation reading doesn't establish a trend, prompting central banks to stay alert about inflation and potentially delay interest rate cuts as long as the economy doesn’t show significant signs of slowing down.

In Canada, headline inflation surged unexpectedly to 2.9% in May while consensus was expecting it to drop to 2.6% from 2.7% in April, challenging expectations for a rate cut next month. Trimmed and median core inflation also ticked higher ending a four-month streak of lower readings. The only measure to continue to decrease was core common CPI, suggesting that while inflation is increasing broadly, the most significant price increases come from certain stable categories captured by the trimmed and median CPIs, but not but the common CPI. The latest data makes it unlikely for the Bank of Canada to cut rates next month.

In Australia, headline inflation increased for the third straight month since February, with the core reading tilting up from 3.5% in April and March to 3.7% in May. Last week, the Reserve Bank of Australia indicated it would take necessary measures to control inflation, including potential rate hikes. The latest inflation data strengthens the likelihood of further tightening in the upcoming meetings.

In the US, traders expect the core PCE to decrease to 2.6% in May from 2.8% in April. While this forecast seems reliable based on existing data, it shouldn't create expectations for more policy easing than currently projected. Core PCE has been steadily declining each month since January 2023, but at a slower pace recently. Bond markets are pricing in 44 basis points of rate cuts by December this year. However, recent comments from Federal Reserve officials indicate that the central bank remains data-dependent and may not cut rates unless the economy shows more significant signs of cooling.

While preliminary CPI data for the Eurozone will be available next week, the focus this week will be on the 1- and 3-year Eurozone CPI expectations. These inflation expectations are crucial because they influence consumer and business behavior. If inflation is perceived to remain high, it could trigger a feedback loop, increasing inflation pressures as workers and unions demand higher wages.

The 1-year Eurozone CPI expected rate has dropped for three consecutive months and is projected to have decreased further to 2.8% in May. In contrast, the 3-year CPI expected rate has been fluctuating between 2.4% and 2.5% since November, and it is expected to have remained steady at 2.5% in May. If the data meet expectations, it's unlikely that a favorable CPI figure next week will boost expectations for further interest rate cuts.

Markets are currently pricing in another 46 basis points of rate cuts by the ECB by December, following the rate cut in June. However, with inflation still above the ECB's 2% target and having rebounded slightly in May, it's unlikely that policymakers will signal a willingness to cut more than what is currently priced in. This is especially true with the Federal Reserve on hold and a weak euro.

Impact on bond markets: higher neutral long-term interest rate may hinder a bond rally.

The economy's "neutral rate" (the borrowing cost level that neither stimulates nor slows growth) is now believed to be higher than previously thought. A higher neutral rate suggests fewer rate cuts and higher interest rates over the next decade compared to the past ten years.

The bond futures market expects policy rates to bottom out at 3.6% in 2027 before rising again, which is about 85 basis points higher than what currently forecasted in the Fed’s dot plot. This higher neutral rate sets a floor for yields across tenors, meaning they are unlikely to drop much lower than the expected neutral rate. As the yield curve normalizes, 10-year yields are expected to be around 100-150 basis points above the Fed's fund rate. Assuming a long-term neutral fund rate of 3.6%, the fair value of US Treasury yields should be between 4.6% and 5.1%.

Therefore, further bond gains depend on the upcoming Fed’s interest rate cutting cycle, which may be limited unless there is a significant slowdown in inflation and growth. This is why, despite expectations of rate cuts this year, long-term bond yields in Canada, Australia, and the US have all risen.

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