Living with US Inflation

Theories galore on why the Fed would be reluctant to raise rates
Discussions in the financial markets continue to revolve around when the Federal Reserve might reduce interest rates, rather than contemplating any potential rate hikes. It appears the U.S. has grown increasingly tolerant of higher-than-expected inflation rates.
 
With inflation remaining sticky, market participants of late have also wondered if there’s a remote chance of a Fed rate hike. We rule that out, however. There are several theories that explain the Fed’s reluctance to increase rates. First, with the presidential election looming, the Fed is likely aiming to avoid the controversy that a rate hike could stir during such a critical period. Additionally, raising rates could escalate the cost of servicing national debt. The Treasury has recently issued a significant amount of short-term debt, anticipating that short-term interest rates might soon peak, which would enable refinancing at more favorable rates. Historically, the Treasury has avoided issuing long-term debt to prevent locking in high financing costs, hoping instead for a decrease in inflation and subsequent rate cuts by the Fed that would lead to lower long-term interest rates. Contrary to these expectations, the current situation sees a strong likelihood that the Fed will avoid rate hikes, as doing so could cause a uniform increase across the U.S. yield curve, thereby raising the government’s funding costs. The year 2024 is pivotal for U.S. government debt refinancing, with about 30% of the debt stock due for refinancing.
 
Bonds – concerns may build about Central Bank accommodation of inflation
US bonds had a tough last week with yields moving up across the curve – US 10-year yields rose 10bps to 4.52%. Spreads also widened (US high yield +12bps) as the markets interpreted the repercussions of higher-for-longer rates as challenging for credit markets. 
 
The three- to six-month outlook for US bonds is tricky. While on the one hand the market does not see that inflation is getting out of hand, on the other the lack of rate cuts and the Fed potentially going soft on current inflation could put more of a risk premium into government bond yields. Again, the coming rise in headline inflation due to the rise in energy prices will likely lead to significantly unnerving spikes in headline inflation through the current quarter. Also the more that the Fed appears to be accommodating higher inflation the more there is a risk that longer dated US government bonds may see higher yields.
 
While the US will internalize its debate about the appropriate path for interest rates, there are international repercussions that add complexity to global markets.
 
What will Europe do?
Last week, the ECB kept interest rates unchanged but indicated for the first time in this cycle that it was prepared to cut rates if inflation continued improving.
 
However, the stickiness of high US inflation and rates could limit the amount of any future ECB monetary loosening. A rate cut in June looks likely, however the market is becoming concerned that events in the United States may limit the scope for any rate cuts beyond June. The performance of the euro during this period will be critical. A marked weakness in the euro would precipitate inflation concerns at the ECB. There are already some concerns that the eurozone still has relatively strong service sector inflation and that wage growth is accelerating.