Bond market set for fresh take on its burning inflation question

A larger-than-forecast jump in wage growth in August has sharpened the focus on the burning question of whether inflationary pressures will prove transitory as Federal Reserve officials project.

Bank of America Corp. strategists say that if Tuesday’s inflation figures back up the transitory narrative, it will lift the odds that long-term yields remain low for the next six to 12 months. The report is forecast to show a fourth straight month of the consumer price index gaining at an annual pace of 5% or greater.

Others are more wary. Macquarie Group’s Thierry Wizman sees a risk that inputs such as rental costs may boost consumer prices, reinforcing concern that elevated inflation will persist. He sees that scenario leading traders to pull forward bets on the timing of Fed tightening, which would tend to push up shorter-term yields disproportionately. So he advises wagering on a smaller gap between long- and short-dated rates.

“I prefer to stick to the 2-3-year part of the curve, since this better reflects what may happen within the Fed’s ‘visible’ policy horizon,” Wizman, a global interest rates and currencies strategist, said via email. “Into the release, I would be short” that area, betting on flattening.

The yield curve has mostly been treading water for weeks — and volatility has been crashing — as traders have stuck to expectations that the Fed likely won’t start raising its benchmark rate from zero until early 2023.

Flattening view

The 2- to 10-year yield gap is around 110 basis points, down from above 140 in early June. The curve narrowed initially as traders bet that a Fed move to taper its bond purchases as soon as this year would pave the way for the start of rate hikes.

But more recently it’s remained flatter in part as surging coronavirus cases tempered expectations for the pace of the economic rebound from the pandemic. U.S. hiring slowed sharply in August. However, earnings climbed from the prior month by twice as much as forecast as companies lifted pay to attract candidates.

The Fed calendar is empty before the central bank’s Sept. 22 policy decision, so investors will have to wait until then to get the latest take from officials on the inflation question.

Investors are positioned for the transitory scenario, says Adam Kurpiel, head of rates strategy at Societe Generale. He sees that in the fact that short-term measures of inflation expectations are below those with longer maturities.

The 10-year breakeven, which represents the market’s view on the annual pace of consumer-price inflation for the next decade, is about 2.4%, while 2-year rates are around 2.7%.

He’s still bearish on Treasuries, on the expectation that Fed policy normalization is ahead.

“High inflation will only confirm that trend,” he said. “On the inflation front, the substantial progress has been done. We need to look at employment going forward.”

What to watch

• The economic calendar:
  • Sept. 13: Monthly budget statement
  • Sept. 14: NFIB small business optimism; CPI
  • Sept. 15: MBA mortgage applications; Empire manufacturing; import/export prices; industrial production
  • Sept. 16: Retail sales; jobless claims; Philadelphia Fed business outlook; Langer consumer comfort; business inventories; TIC flows
  • Sept. 17: University of Michigan sentiment
• The Fed calendar is empty
• The auction calendar:
  • Sept. 13: 13-, 26-week bills
  • Sept. 16: 4-, 8-week bills