Investors expect higher interest rates as inflation pressures mount

Stronger than expected US inflation and a bump in consumer spending have fuelled worldwide expectations that interest rates will go higher, as predictions about future monetary policy rapidly shift.

The Federal Reserve’s preferred measure of inflation overshot expectations in April, data published on Friday showed, while US consumer spending rose last month and new orders for long-lasting goods unexpectedly increased.

Kristalina Georgieva, the IMF’s head, on Friday warned US interest rates would need to stay higher for longer to tame inflation that had been more persistent than anticipated. She added that a loss of confidence in US Treasury markets would mean turmoil for the global economy.

Yields on short-term government debt in the US, UK and eurozone have begun to rise again as investors switch from betting on an economic slowdown to anticipating more prolonged rate increases to contend with price rises.

The shift in rate expectations marks a big change for fund managers and traders, who have spent much of the year trying to predict when central banks would start cutting interest rates.

Futures markets are now pricing in a 37 per cent chance of another interest rate rise by the Fed in June, having previously anticipated that the next move would be a cut.

The yield on two-year Treasury bonds — particularly sensitive to investors’ interest rate expectations — has risen to 4.6 per cent, from a low of 3.7 per cent earlier this month. Yields rise as prices fall.

Adding to the indications that the US economy is still moving ahead, personal consumption, adjusted for inflation, increased 0.5 per cent in April from a flat reading in March, as spending on services such as insurance and healthcare picked up.

“We keep on getting surprised by the inflation data to the upside and that is an issue,” said Florian Ielpo, head of macro at Lombard Odier Investment Managers.

Durable goods orders, which include washing machines, cars and aircraft, increased 1.1 per cent from the previous month — above economists’ expectations for a 1 per cent decline. 

Developments in US debt ceiling negotiations have also pushed US yields higher as White House negotiators seek to conclude a deal with the Republican leadership of the House of Representatives this weekend.

European and UK yields have also risen. The yield on UK two-year debt jumped as much as 0.6 percentage points this week to over 4.5 per cent, its highest level since October. The equivalent German bond yield has gone from around 2.5 per cent early this month to just under 3 per cent.

Investors have been particularly unsettled by high core inflation — a measure that strips out volatile food and energy prices — which puts pressure on central banks to raise rates further, even at the risk of recession.

“We are definitely not out of the danger zone yet,” said Sonja Laud, chief investment officer at Legal & General Investment Management.

In a recent note, analysts at BlackRock said most developed economies “are grappling with a shared problem . . . core inflation is proving more stubborn than expected and remains well above central banks’ 2 per cent targets”.

“We think that means central banks can’t undo any of their inflation-fighting rate hikes any time soon,” they wrote.

Earlier this month, markets had priced in one more rate rise by the European Central Bank to 3.5 per cent, but futures markets now expect the rate will peak at 3.7 per cent by October.

“Europe is effectively just behind where the US is in the economic cycle so we think the ECB has further [rate increases] to go,” said Mark Dowding, chief investment officer at BlueBay Asset Management.

In the UK, data published this week showed that core inflation rose by 6.8 per cent in the year to April, faster than economists had predicted. 

Imogen Bachra, head of UK rates strategy at NatWest, called the figures a “game changer” for interest rates. Swaps markets are pricing in a peak Bank of England rate as high as 5.5 per cent by November, up from 4.9 per cent a week ago, a much higher than the current 4.5 per cent.