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Commodity inflation has stopped behaving like a temporary input to bond pricing and started behaving like a permanent one. With the latest U.S. consumer price print landing in line, the producer price print landing flat, and the U.S. Treasury curve moving on crude oil anyway, the market is no longer trading inflation data as its primary signal. What matters most is where on the curve that pressure sits, because the oil correlation runs strongest in the 10 year rather than the two year, the point that usually absorbs a central bank response. For anyone reading inflation releases to position a fixed income book, the release itself has become the weaker input.
Shriya Samarth is Executive Director and Head of Rates, EMEA at StoneX Financial Ltd, a London based G3 rates specialist who tracks U.S. and European sovereign debt, gilt market liquidity and yield curve positioning for institutional clients. Her coverage runs to how inflation expectations and energy shocks feed through to fixed income pricing, which is the exact channel at work when commodity inflation prices into the long end of a sovereign curve.
"Inflation is no longer the story in the markets or on the trading floor", Samarth says, and the U.S. Treasury market's behavior around the latest releases backs her up. U.S. July CPI met expectations at 3.4% headline and 2.5% core, with energy decelerating on gasoline prices, while U.S. July PPI came in flat month on month. Samarth notes it can take "3 to 9 months for oil prices to actually trickle down into CPI prints", so a release describes energy conditions from months earlier rather than the ones the market is absorbing now. As a result, fixed income participants are pricing the commodity itself rather than the statistic, and the inflation calendar has lost much of its power to move the curve.
The strongest link between crude oil and the U.S. Treasury curve sits in the 10 year point, not the front end where a policy reaction would normally register. According to Samarth, "the correlation is strongest in the ten year point of the U.S. Treasury curve, which is interesting because usually you see this first play out in the two year point". In the usual sequence a supply shock generates inflation and central banks respond by hiking rates immediately, which registers in the two year segment, so a correlation that has migrated to the belly of the curve implies the market has stopped expecting policy to clear the problem. Samarth puts the conclusion plainly, that "the markets think that inflation in some way, shape or form is here to stay because of oil, and we're just going to have to learn how to trade that".
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--- Written by Gus Farrow, Senior Manager, StoneX Media
--- Expert: Shriya Samarth, Executive Director and Head of Rates, EMEA
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