Bond yields rise as inflation expectations edge higher

Key Takeaways

• Rising energy prices are lifting inflation expectations, a key component of bond yields.
• Markets have pushed back the implied timing of Fed rate cuts, reflecting a more patient policy stance if inflation stays above the 2% target for longer.
• We still think the Fed remains in its rate-cutting cycle, likely moving the policy rate toward 3.0%-3.5% by year-end, though the pace may slow.
• Bonds often benefit from market stress, but they can be sensitive to inflationary shocks.
• Higher yields mean bonds offer more income, and any easing in inflation expectations could boost bond prices, which move inversely to yields.

Rising oil prices drive inflation expectations higher

Oil and natural gas prices have moved higher amid production cuts following attacks on energy infrastructure in the Middle East. In addition, crude and liquefied natural gas (LNG) tankers have been delayed or rerouted due to disruptions in the Strait of Hormuz, which carries roughly 20% of global energy supply.

Market-implied inflation expectations — measured by breakeven rates in the Treasury Inflation-Protected Securities (TIPS) market — have been a key contributor to the recent rise in bond yields, accounting for just over half of the move, shown in the chart below.

The 10-year Treasury has returned more firmly within our 4.0%-4.5% expected range for the benchmark yield. Additional Fed purchases of Treasury bills should help anchor the short end of the yield curve near the fed funds rate, likely limiting upside pressure on yields. Conversely, resilient economic growth, persistent fiscal deficits and inflation risks typically drive yields higher, making a sustained drop unlikely, in our view.

While bonds often benefit from market disruptions, they can be susceptible to inflationary shocks. On a positive note, higher yields improve bonds' income potential. In addition, any easing in inflation expectations could lift bond prices, which move inversely to yields.

Higher inflation could slow the pace of Fed cuts

Bond markets also imply that higher inflation could delay Fed rate cuts. Shown in the chart below, markets currently expect one policy rate cut later this year, followed by another cut next year, taking the Fed funds target range to 3.0% - 3.25%.

The Fed will release its quarterly projections for the Fed funds rate, inflation, unemployment and economic growth following the conclusion of its Federal Open Market Committee (FOMC) meeting on March 18. Investors will surely watch for any shifts in policymaker views on the economy and the likely monetary-policy path.

We still think the Fed remains on its rate-cutting path, likely moving the policy rate into the 3.0%-3.5% range by year-end. However, the labor market that is characterized by slower hiring and fewer layoffs may give policymakers more time to confirm that Personal Consumption Expenditures (PCE) price index inflation — currently 2.9% — is cooling sustainably toward the 2% target before delivering additional cuts. Additional monetary policy easing should help gradually reduce borrowing costs for households and businesses, likely supporting consumer spending and corporate earnings.

^{Source for all data not cited: FactSet as of the date of this report, unless otherwise noted.}