Yesterday's inflation print proved to be unacceptably hot. While headline CPI did dip to 8.3% YoY in April (from 8.5%), the moderation was far less than consensus expected. CPI momentum is still strong with our calculations showing inflation running between 6 to 10% annualized. Breaking down into the components, the details are also worrying, with increases in services inflation as price pressures broaden out.
US Treasuries sold off across the curve with 10Y yields briefly popping above 3%. However, risk aversion quickly took hold as stock indices tumbled sending 10Y yields back to 2.92%. Meanwhile, breakevens, which had erased the Ukraine-Russia conflict inflation premium, also rose after the CPI release. The overall theme was one of caution as the market starts to weigh high inflation, Fed policy and recession risks.
Financial conditions are still showing a significant amount of stress, which probably acts to cap upside in long-term yields despite elevated inflation pressures. That said, we think that the Fed may have greater tolerance for market stress (as compared to the past three decades where inflation is not a problem) and further tightening is unlikely to be derailed.
We remain in the flattening camp as we expect the Fed to try and rein in inflation. Meanwhile, recession fears are also likely persist. We also like to receive 2Y/5Y/10Y fly. Lastly, the fall in implied real yields is a reflection of risk aversion and not due to expectations that the Fed would loosen up. In the short term, we are neural around 3%. If 10Y nominal yields head significantly lower from 2.90%, a tactical pay might be in order.
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