Update Bonds: Inflation cools, rate cuts approach
The weaker than expected US employment report on 2 August was a source of volatility at the start of the month. Markets feared that the US Federal Reserve was “behind the curve” and keeping rates too high for too long, potentially pushing the economy into a recession. This week’s inflation data provided some relief.
On Wednesday, the Bureau of Labor Statistics published the Consumer Price Index (CPI) for July, following the release of the Producer Price Index the day before. Both reports were reassuring. They indicated that US inflation is slowly but steadily heading towards the central bank target of 2%. For the first time since March 2021, the CPI inflation rate fell below 3% year-on-year.
The inflation reports brought some relief to markets. US Treasury yields dropped, as investors became more confident that the Fed will ease rates at its next meeting in September. This expected rate cut, the first since the central bank began its hiking cycle in 2022, is likely to mark the start of a longer easing period. This outlook has pushed bond yields lower this summer, with shorter-maturity yields being particularly sensitive to this trend. (When bond yields decline, bond prices rise.) The US Treasury yield curve has been inverted for over two years, the longest period of inversion in history. Last week, two-year and ten-year Treasury yields nearly converged, signalling a flattening yield curve that may indicate a shift to a more normal, upward sloping curve in the coming months.
In Europe, the European Central Bank has already begun its rate-cutting cycle (and will gain more flexibility with the Fed’s first move) and is expected to continue cutting rates through the rest of the year. When central banks cut rates, high-quality bonds tend to perform well. Investors holding long-maturity investment-grade bonds can lock-in today’s more attractive yields and benefit from potential lower yields in the coming months.