After the employment data, the US yield curve dipped sharply, led by the belly of the curve, as expectations of rate hikes in 2023 were pared back. However, the subsequent focus on inflation brought the curve back up and through the recent highs. We expect the US yield curve to remain supported by a strong underlying growth trajectory and near-term price pressures. Furthermore, we remain of the view that the US labour market is stronger than the April data suggests, and that the current average pace of job gains of approx. 500k per month over the past 3 months will be comfortably surpassed in the coming months.

As far as the USD is concerned, I feel that the testimony of the Fed Vice Chair is important in relation to the debate over the transience of inflation and the monetary policy reaction function. The Vice Chair was clear to point out that the Fed are watching the data very closely and that policy is outcome-based, not time-based. Further, he was clear that if the data pointed to a more pronounced or persistent inflation, then the Fed would not hesitate to use its tools to bring inflation back to its medium-term objectives. From my perspective, this should put more of a base under real yields: if you are of the view that inflation is more persistent, then you should likely also expect an earlier policy response. Furthermore, with the absolute level of real yields still supportive of US assets (and real assets), capital flows should continue to support the USD.

In general, we prefer to think of inflation as a global factor with open economies and global supply chains. Thus, as output gaps remain significant globally and demand lagging or differentiated across the globe, we continue to see inflation as ultimately transitory. Further, while there is likely to be excess demand in the US for some time to come, it will likely ultimately result in a deterioration of the current account, as the US excess demand sucks in imports from abroad. This too will damp the inflationary impulse until the supply side catches up.

It could be argued that the resultant deterioration of the current account deficit could be viewed as a negative for the USD; rather, we consider the capital account a more important driver of the USD than the current account, essentially suggesting that global demand for US assets is far greater in nominal value that the trade imbalance driven by excess US demand.

Over recent weeks, we have spoken about our core view of differentiation in recovery from the Covid crisis – unlike the synchronised recovery from the Global Financial Crisis. We are also of the view that the current inflation impulse and higher USD yields will likely have the effect of exacerbating this differentiation.

Rising US rates ought not be a problem for the US: the growth impetus is very strong and the absolute level of yields (particularly in terms of short-term funding) remain historically very low. Higher interest rates in the US, however, may prove more troublesome for countries outside of the US, either directly or through correlated domestic moves higher in the cost of funding. This mismatch is likely to widen the growth dominance of the US over its G10 peers, from our perspective.

On a similar note, it is also clear that the broader rally in yields – as a function of rising US growth and inflation prospects – has exacerbated the rise in Bund yields, though we acknowledge that, at least in part, the move is also a function of positive reopening and growth rebound expectations for Europe. Indeed, expectations that the June European Central Bank (ECB) forecast round will bring sharply higher growth forecasts and the announcement of a ‘tapering’ of the increased pace of PEPP purchases through Q2 have also played a part. On this point, we remain a little more sanguine, not necessarily on the basis that the ECB will not reduce the pace of PEPP purchase (though it is not clear why the ECB should be proactive when other central banks have stated very clearly their intentional reactiveness), but that - like the Bank of England (as discussed last week) – we expect the ECB to stress that the monetary stimulus comes from the stock of assets.

The issue from our perspective is that rising yields across the eurozone, in conjunction with a reduced pace of PEPP purchases, is likely to put pressure on higher and wider peripheral spreads. At this critical point of the recovery, where credit dynamics are most stretched (even if the recovery fund plans of some European states are very encouraging), small incremental increases in the cost of funding very high debt levels could have a very high opportunity cost in terms of lost growth potential.

The backdrop has been very volatile of late (...enough to drive you crazy if you let it?), but our core views on a positive, USD-led recovery with key global differentiation remains.