The Federal Reserve's reluctance to lower interest rates, coupled with a lack of forward guidance, is sending ripple effects through the market, pushing both nominal and real yields higher and steepening the US Treasury yield curve.
While these effects have yet to fully materialize from a historical perspective, the impact on risk assets will eventually become apparent as real yields rise. For now, the increase in real yields may simply not be large enough to trigger a significant response. Consequently, the US July Consumer Price Index (CPI) report, due this week, could serve as a kind of stress test. The report follows a weak nonfarm payrolls report that did not lead to a notable decline in 10-year and 30-year Treasury yields. The market's reaction to the CPI data may offer a clearer signal. The market currently expects the July CPI report not to show an overheating in inflation. However, analysts project a 0.1% month-over-month increase in headline CPI, up from a 0.4% decline in June, while the year-over-year pace is expected to be 3.4%, slightly below June's 3.5%. Core CPI, which excludes volatile food and energy items, is expected to rise 0.2% month-over-month, compared to a flat reading in June, with a year-over-year pace of 2.5%, down from 2.6% in June. In contrast, market-based predictions from platforms like Kalshi suggest a 0.1% month-over-month and 3.3% year-over-year rise in headline CPI, with core CPI increasing 0.2% month-over-month and 2.4% year-over-year. Meanwhile, CPI swaps are pricing headline CPI growth at 3.4% year-over-year. On the surface, Kalshi's forecast appears to align with the consensus on a month-over-month basis but might indicate a lower-than-expected year-over-year reading. Kalshi's predictions could actually provide more noteworthy information, as they might generate a more significant market transmission effect. One possibility is that even if year-over-year CPI comes in below expectations, it may not lead to a clear shift in long-term interest rates, similar to the market reaction after the nonfarm payrolls report.
Inflation Is Not the Sole Driver of Rising Rates
Currently, inflation expectations might be a factor pushing rates higher, but they are not the only one. In fact, the 10-year breakeven inflation rate has been declining since mid-May, even as the 10-year Treasury yield has continued to climb. This suggests that real interest rates are rising. This also breaks the cyclical pattern of synchronized changes in nominal rates and inflation expectations seen previously. It indicates that other factors are likely driving rates higher, with inflation not being the sole catalyst. One prominent factor appears to be the term premium, which is the additional compensation investors demand for holding long-term US government bonds. Indeed, the 10-year real yield is now higher than the 10-year breakeven inflation rate. This is the first time this has occurred since the 2008 financial crisis, with the previous instance in 2007. This marks a significant shift and could mean the market is regaining control of the inflation narrative, pushing long-term rates high enough to address issues the Fed is perceived as unwilling to proactively tackle. The gap between real yields and inflation expectations crossed and reversed on June 22. This date coincides with the aftermath of the June Federal Open Market Committee (FOMC) meeting, Kevin Warsh's first press conference, and the Fed's removal of forward guidance. If the market is re-entering an "inflation-fighting" mode, breakeven inflation rates could fall further as real yields rise. If the 10-year real yield increases by another 25 basis points, the 10-year breakeven inflation rate could drop to 2%. This level has been a focal point around 2% for years and is also the Fed's inflation target.
Broader Market Implications
Typically, a rise in real yields is viewed as negative for risk assets, as historical experience suggests. It is possible that real yields have simply not yet climbed to a level that can break the upward trend in risk assets. Historically, market turning points have occurred at different real yield levels: in the late 1990s, the 10-year real yield rose to 4%, eventually bursting the internet bubble; in 2007, real yields neared 3% as the housing bubble burst; in 2018, real yields reached 1%, leading to a sharp market decline at year-end; and in 2021, real yields rose to around 1.7%, triggering a market correction. It is difficult to determine the exact threshold now. However, given the rising trend in real yields, it may require a level closer to 2.7% to 3% to truly challenge the current AI bubble. Another possibility is that real yields are still too low to have a significant impact. This is because the spread between the S&P 500's next twelve months (NTM) earnings yield and the 10-year Treasury Inflation-Protected Securities (TIPS) yield is currently only 2.6%. Before the 2000 internet bubble burst, this spread actually turned negative.
The Significance of the July CPI Report
Therefore, the July CPI report provides a noteworthy market observation opportunity. The more interesting outcome is not if CPI comes in higher than expected, but how bond yields react if it comes in lower. If yields refuse to decline following a significantly weak nonfarm payrolls report and a lower-than-expected CPI reading, this signal could be more valuable than any single upside inflation surprise. This serves as a reminder to market participants that undiscovered information is always present in the market, even when it is not immediately obvious.
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