We remarked on Monday’s notable calming in market circumstances, as volatility dipped, bond yields rose and risk was put back on again. A lot of that completely reversed early Tuesday, and even though there was something of a subsequent calming as the day progressed, a more menacing tone obtained overall. We’re left with the impression that the markets want this movie to play out a bit more before taking a conclusive stance. That’s probably fair.
Ahead, we risk seeing bouts of flight to safety, pushing yields down. Don’t rule out a break back below 4% on the US 10yr, even if brief, likely on a risk-off episode should things turn really sour. This could see the 10yr Bund yield trekking back towards 2.5%. But as we look into the second quarter, we anticipate the US 10yr yield to get back up to the 4.3% area (a level that obtained for a period in January). That equates to the German 10yr yield getting back up to the 2.9% area. This reflects a resultant higher inflation narrative (higher energy prices). Beyond that, a subsequent calming in yields through the second half of the year would reflect the payment for that in terms of a hit to real growth. That’s the way we see it for now, and we’ll update as we progress through an uncertain number of weeks ahead.
And for the Federal Reserve, the timing of the Warsh rate cuts will be pressured towards a wait. But they should still ultimately come, so long as medium-to-long term inflation expectations remain contained.