US bond market shrugs off higher than expected inflation data

• The bond market shrugged off the fastest US inflation rate in over a decade, with the 10yr yield ending last week 10bp lower at 1.45% despite headline CPI accelerating 0.6% m/m and 5.0% y/y in May, higher than the consensus forecast of 4.7% y/y and up from April’s 4.2%. More than half of May’s inflation was attributed to “transitory” factors as a result of the reopening of the economy and shortages of some goods. Used car prices (7.3% m/m), car rental costs (12.1% m/m), airfares (7.0% m/m), car insurance, hotel rates, and restaurant prices all contributed to the faster CPI inflation in May. Core inflation rose to 3.8% y/y from 3.0% in April.  The low annual base of Q2 2020 means the annual inflation rate is likely to remain elevated over the coming months, before slowing from Q3 21. 
• There was some evidence in the preliminary University of Michigan consumer sentiment survey for June that inflation may be weighing on consumer demand.  The headline index rose slightly to 86.4 in June but remains well below pre-pandemic levels, and while inflation expectations were slightly lower than in the May survey, consumers were concerned about high car and house prices.
• All eyes will be on the FOMC meeting this week.  While we expect the Fed to maintain that recent inflation is transitory, there is some expectation that policy makers will start to talk about talking about tapering.  However, with unemployment still high, we do not expect any actual tapering until 2022, even if the Fed changes its tone in the coming months. Before the FOMC concludes its meeting on Wednesday, retail sales and industrial production data for May will be released on Tuesday.
• At its policy meeting last Thursday, the ECB maintained its PEPP asset purchases at a “significantly higher pace” than in Q1, despite expectations that it might start to scale this back.  The language was surprisingly dovish given the upward revisions to the ECB’s economic forecasts, with GDP growth now expected to reach 4.6% this year (previous forecast 4.0%), and 4.7% in 2022 (previously 4.1%).  Nevertheless, the ECB expects inflation to remain below its 2% target through 2023, despite the recent increase which the bank attributes to temporary factors.
• UK GDP grew 2.3% m/m in April, up from 2.1% in March, driven by the reopening of the services sectors.  Construction and industrial production declined m/m, with the latter reflecting the shortage of inputs for car manufacturing as well as maintenance on oil platforms. While reports over the weekend suggest the removal of remaining (relatively minor) restrictions may be delayed beyond 21 June as a result of the rise in coronavirus cases in the UK, this should not prevent the economy from continuing to recover in the coming months.
• The value of Dubai’s non-oil foreign trade grew almost 10% y/y to AED 354.4bn in Q1 2021.  Direct exports grew 25% y/y while imports grew 9% y/y.  No data was provided on the value of Dubai’s re-exports.  The volume of global merchandise trade has recovered strongly since the start of the year, buoyed by consumer spending in developed markets, which should support a rebound in the emirate’s key transport & logistics sector this year.
• At the G7 leaders' summit in Corwall, UK, over the weekend and agreed to greater co-ordination and collaboration to ensure more sustainable and resilient growth as well as tackling health and climate challenges and inequality.  A task force was set up to examine how the G7 countries could boost investments in emerging markets, an effort by the US to push back against the China's Belt and Road initiative.  The G7 also pledged to provide one billion Covid-19 vaccine doses over the next year.

Today’s Economic Data and Events

• 08:30 Japan industrial production (Apr)

Fixed Income

• Benchmark government bonds had a strong weekly performance as markets accept the transitory inflation argument from central banks. An index of US Treasuries rallied 0.48% over the week, its best weekly performance since November 2020. The May CPI inflation print of 5% y/y caused an initial pop higher in UST yields before they sank during the rest of the day as markets took a deeper look at the drivers of higher prices, largely items related to the reopening of the economy such as used cars or travel and hospitality.
• Yields on the 2yr moved up to more than 0.16% on the data then faded and closed out the week at 0.1469%, about stable week/week. The 10yr UST saw more action though with yields falling to as low as 1.4266% on Thursday before recovering at the end of the week and ending the five days down around 10bps at 1.4518%.
• For European bond markets, the commitment from the ECB at their June meeting to maintain their elevated pace of purchases helped to take out some of the recent rise in bond yields. Yields on 10yr bunds fell 6bps to -0.274% after having reached as high as -0.10% in mid-May.
• Emerging market bonds also managed to rally in line with sinking developed market yields. Turkish 10yr yields fell more than 20bps to push back well below the 18% figure to close the week at 17.83%. In South Africa, bonds remain well bid with yields on the 10yr government bond down by 15bps to 8.975%, their lowest level since the start of May while in India yields on 10yr government bond fell 2bps to 6.008%.
• Dubai Aerospace Enterprise has mandated banks for a USD issuance in coming weeks. Fitch affirmed its rating on DP World at ‘BBB-’ with a stable outlook while S&P affirmed their ‘BBB+’ rating on Commercial Bank of Qatar with a positive outlook.
• Central bank action this week is dominated by the US FOMC (June 16) where focus will likely be on whether the Fed’s language doubles down on the transitory inflation argument. Among the other major central banks meeting this week the Bank of Japan is expected to hold policy unchanged on June 18 while Indonesia, Egypt, Turkey, Taiwan and Switzerland all have central bank meetings on June 17.

FX

• The broad dollar index had its best week since late April despite the drop in UST yields. Currency markets may be adjusting some of their short dollar positions, helping to put a floor under selling that occurred earlier in Q2. Net length in EURUSD futures and options fell back slightly last week and is well off its elevated level hit earlier in 2021.
• The Euro accounted for most of the move higher in the dollar as the single currency fell 0.48% to 1.2109 at the close. The persistently dovish stance from the ECB, even if there is reportedly some dissent on the pace of asset purchases over the coming months, will act as a headwind to the euro even though the underlying economic conditions in the eurozone are improving.
• The move in USDJPY was far more muted with the pair rising by just 0.13% over the week. The yen seems anchored either side of 109.50 in the near term with levels around the 109 figure providing some resistance. However, to push substantially higher to fully retrace to the 110.97 high in the past year would likely require a considerable push higher in the dollar, perhaps from a hawkish turn at the FOMC which we think is unlikely.
• Sterling also sank last week, declining by 0.35% to 1.4107. The pair has been relatively steady around current levels but the risk of the end to all lockdown measures being delayed has increased recently with a potential drag effect on activity in the summer months.

Equities

• Global equity markets shrugged off the spike in May inflation reported last week to hit fresh record highs as investors start to accept the central bankers’ argument that this is transitory and won’t prompt a rapid tightening of policy. In the US, the S&P 500 gained 0.4% over the week to its highest ever close, while the NASDAQ gained 1.9% but remained off its April peak. The Dow Jones slipped -0.8% w/w however.
• In Europe, the composite STOXX 600 also hit a new record high with a 1.1% w/w gain. The outlook in Europe continues to improve as vaccination programmes are rolled out, and France’s CAC gained 1.3% w/w. In the UK the FTSE 100 hit its highest close since February 2020 with a 0.9% gain over the week, despite the increasing likelihood that the June 21 relaxation of restrictions will be pushed back.
• Asian equities were more mixed last week. In India, the benchmark indices continue to benefit from an improving outlook there, and the SENSEX (0.7%) and the NIFTY (0.8%) both closed higher w/w. The Nikkei closed flat on the previous Friday, but the Hang Seng (-0.3%) and the Shanghai Composite (-0.1%) both lost ground over the week.

Commodities

• Oil prices extended gains last week, rising for a third week running. Brent futures added 1.1% to close at USD 72.69/b while WTI settled the week just shy of USD 71/b, a gain of 1.9%. The IEA’s oil market report was in play with the agency suggesting that oil markets will tighten considerably in H2 2021 and into next year if OPEC+ maintains its existing production quotas in place.
• Negotiations on Iran’s nuclear programme will kick off again this week although officials from the country seemed to downplay the prospect of a deal being reached ahead of presidential elections in Iran later this month. The prospect of Iranian crude returning unfettered by sanctions is being pushed further into H2 2021, helping to provide a floor under prices in the near term.

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