US: Inflation risks and rangebound yields – TD Securities

Inflation Picture: A Temporary Lull?

February's CPI data landed exactly where economists anticipated, offering a brief respite after January's unexpectedly high figures. Specifically, the core inflation rate saw a welcome decline. The supercore measure, which excludes food and energy, also cooled down from January’s tariff-related surge, decreasing from 0.59% month-over-month to 0.35% in February. This suggests that some of the earlier inflationary pressures may be easing, at least for now.

However, this backward-looking data may not fully capture the current environment. The elephant in the room is the ongoing surge in oil prices, which threatens to reignite inflationary pressures in the coming months. The expectation is that core PCE, the Fed's preferred inflation gauge, will show a firmer reading, with preliminary forecasts pointing to a 0.31% month-over-month increase. The anticipation is that rising energy costs will lift headline inflation closer to the 3% mark, creating a complex situation for policymakers.

Treasury Yields Stuck in Neutral

Despite the mixed inflation signals and the potential for further energy-driven price increases, US Treasury yields are expected to remain within a relatively tight range of 4.0% to 4.3% for the 10-year note. This suggests a degree of market complacency or, perhaps, a belief that the Fed will maintain its current patient stance.

While yields briefly broke out of this range amid geopolitical tensions in Iran, they quickly reverted, indicating a strong gravitational pull back to the established levels. The expectation is that this range-bound trading will persist until the second half of the year, as investors await greater clarity from the Fed regarding its future policy moves.

Buying the Dips?

The current market environment presents opportunities for strategic investors. The recommendation is to consider buying dips in nominal and real rates when they approach the upper end of the 4.0-4.3% range. However, there's a caveat: real rates are expected to outperform nominal rates, reflecting concerns that inflation could prove more persistent than currently anticipated. This suggests a preference for inflation-protected securities as a hedge against potential upside surprises in price pressures.

What Smart Money Is Watching

This situation presents a delicate balancing act for the Federal Reserve. On one hand, the central bank must remain vigilant against the threat of rising inflation, particularly given the impact of higher energy prices. On the other hand, premature tightening of monetary policy could risk derailing the economic recovery. Therefore, the Fed is expected to remain patient, carefully monitoring incoming data and geopolitical developments before making any significant policy shifts.

Several asset classes and indicators are likely to be affected. Crude oil prices (WTI and Brent) will remain highly sensitive to geopolitical events and supply disruptions. The USD/CAD pair could see increased volatility, reflecting the close relationship between the Canadian dollar and oil prices. Furthermore, energy stocks may experience increased investor interest as oil prices rise, while broader equity markets could face headwinds if inflation concerns intensify. Finally, inflation expectations, as measured by Treasury Inflation-Protected Securities (TIPS), will be closely watched for any signs of a sustained increase.

Traders should closely monitor the upcoming March CPI report, which is expected to show a significant increase in energy prices. Any upside surprises could trigger a reassessment of the Fed's policy outlook and potentially lead to a breakout from the current range-bound trading in Treasury yields.