Friday Investors Club: US CPI surprises – what's next for the Fed and bonds? (7:28)
Listen in to CIO's Frederick Mellors and Jon Gordon on inflation, rates, and portfolio positioning.

Thought of the day

The yield on the 10-year US Treasury moved up further on Thursday as markets continued to assess the Federal Reserve’s likely next step in the wake of fresh inflation data this week. At 4.59%, the 10-year US Treasury yield stood at the highest level since mid-November, after a climb of more than 70 basis points since the end of last year.

Investors had anticipated a swifter shift to policy easing after the Fed signaled a pivot last year amid falling inflation. But the disinflationary trend appears to have stalled after three consecutive months of higher-than-expected US consumer price index data, raising concerns over higher-for-longer rates.

While shifting expectations around the timing and pace of the Fed’s first cuts are likely to create further yield volatility in the near term, we think the more important point is that the US central bank remains set to start easing this year. With a low probability of the Fed needing to hike rates further, we maintain our positive outlook on quality bonds.

US economic conditions should still allow the Fed to cut. While it’s taking longer than previously expected, we continue to believe that inflation will fall back to closer to the Fed’s 2% target once the shelter component of inflation gauges starts to reflect the actual trend in rental markets. We also expect to see more signs of cooling in the jobs market as wage increases moderate, and believe that economic growth will slow further amid restrictive interest rates. In addition, the fact that higher-for-longer rates erode corporate profitability and raise the risk of financial stress should keep the Fed on an overall easing bias. We now expect the Fed to start cutting rates in September, with a total of 50 basis points by the end of this year.

Yields are still expected to fall despite a reassessment of the Fed’s path to rate cuts. Given the likely delay to the US central bank’s first cuts this year, we have raised our year-end forecast for the 10-year US Treasury yield to 3.85% from 3.5%. But this means we think the risk-reward is still favorable for existing bondholders, as the potential for capital gains remains. Historically, markets tend to price in a series of cuts into the future once the easing cycle begins, pushing the yield lower.

The disinflationary trend outside the US supports our constructive view on quality bonds. Recent inflation prints in Switzerland, the Eurozone, Canada, and the UK all surprised to the downside. Following a first rate cut last month by the Swiss National Bank, the European Central Bank this week indicated that its first move remains likely in June. While the divergence between the US economy and other advanced, open economies is apparent at the moment, inflation over a longer time horizon in these markets tends to correlate.

So, we continue to favor quality bonds in our global portfolios and recommend investors lock in attractive yields before rates fall this year. We like those with 1–10-year duration, as well as sustainable bonds. We also think investors should consider an active exposure to fixed income to improve diversification.