US 10-year Treasury yields spike 10bps back towards 1.55%, on hotter than expected US inflation

• US 10-year yields shot nearly 10bps higher to the mid-1.50s% following hot US inflation data.
• The data puts pressure on the Fed to abandon its ultra-dovish monetary policy stance.

The latest US Consumer Price Inflation report (for the month of October) has triggered a significant move higher in the US 10-year yield. On the day, 10-year yields are up just shy of 10bps, having rallied from around 1.44% to close to the 1.55% mark. That marks the biggest one-day rise since 23 September, when the Fed caught the market off guard with a more hawkish than expected dot-plot.

The move higher in 10-year yields comes amid a broader move higher of yields across the US curve. 2s are up 9bps to above 0.50% again, 5s are up more than 12bps to close to 1.20%, 7s are up nearly 11bps to above 1.40% and 30s are up over 6bps to just shy of the 1.90% mark. The larger move higher of yields in the short-end/belly of the curve means that the US yield curve has also flattened. The 5s/30s spread hit its lowest since Q2 2020 on Wednesday at just above 40bps.

Higher bond yields mean bond prices have fallen. Higher inflation eats away at the value of a bond by reducing the future value of the bond’s cash flow (coupon and principal payments). It was not surprising to see investors dump US bonds in wake of a much hotter than anticipated US inflation report on Wednesday. To recap the details quickly, headline CPI came in at 6.2% YoY/0.9% MoM, both metrics well above expectations, while core CPI came in at 4.6% YoY/0.6% MoM, also well above expectations. The YoY rate of headline CPI hit a fresh highs since 1990.

If market participants still believed the Fed’s argument that the current spike in inflation is set to be transitory and that inflation will on its own come back towards their 2.0% target by the end of 2022 and in 2023, then bonds likely would not have been sold so heavily. But there is increasing evidence that the transitory argument is incorrect, as the latest report revealed inflationary pressures becoming more broad-based. Housing rose 0.7% MoM, food 0.8% MoM and medical care 0.5% MoM. House costs have been getting particular focus as of late given the tendency of the housing cost component in the CPI calculation to follow house price trends over time.

The Federal Housing Finance Agency's House Price Index was up 18.5% YoY in September and some economists are forecasting that the inflation rate of the housing cost component in CPI (which makes up 25% of the headline index and 40% of the core) will reach 4.0% next year, double the Fed’s target. Add to all of the above the growing evidence over the last few months that the US labour market is very tight owing to the labour shortage and that, as a result, wage growth is picking up, and the transitory argument is on shaky legs.

Notably, the demand for medium-term inflation protection was strong. Despite 5-year yields surging more than 12bps, the 5-year TIPS yield (i.e. on the 5-year inflation-protected bond) dropped 5bps. That meant that 5-year inflation expectations rocketed more than 17bps higher on the day. In that context, its not surprising to see gold (widely seen as an inflation hedge) rocket to multi-month highs.

The CPI data and the sharp move higher in medium-term inflation expectations (5-year breakevens suggest inflation will average 3.14% over the next five years) will put heavy pressure on the Fed to abandon their ultra-dovish stance that at the moment leaves than on course continue buying bonds into mid-2022 and then likely not hiking rates until sometime after.