Investors expect higher interest rates as inflationary pressure increases

Stronger-than-expected U.S. inflation and a surge in consumer spending have fueled global expectations for a rise in interest rates as predictions about future monetary policy change rapidly.

The Federal Reserve’s preferred inflation gauge beat expectations in April as U.S. consumer spending rose last month and new orders for durable goods unexpectedly rose, data released Friday showed.

The personal consumption expenditures price index, which measures how much people pay for goods and services, rose 0.4 percent in the month following a 0.1 percent rise in March.

“We are constantly surprised by upward inflation figures, and that is a problem,” said Florian Ielpo, head of macroeconomics at Lombard Odier Investment Management.

Short-term government debt yields in the U.S., U.K. and eurozone have stalled and started to rise again as investors shift from betting on an economic slowdown to longer-term expectations of higher interest rates to combat rising prices.

The shift is a big change for fund managers and traders, who have spent much of the year trying to predict when successive rate hikes will begin to slow the economy, allowing central banks to begin cutting interest rates.

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Futures markets are now pricing in a 37 percent chance of another Fed rate hike in June, having previously expected a cut next.

A line chart of two-year government bond yields (%) shows bond yields rising as economic data stokes inflation fears

The yield on two-year Treasury bonds – which are particularly sensitive to investors’ interest rate expectations – rose to 4.6 percent from a low of 3.7 percent at the beginning of the month. Yields increase as prices fall.

In addition to signs of continued progress in the US economy, personal consumption adjusted for inflation rose 0.5 percent in April compared to March’s level, while spending on services such as insurance and health care rose.

Orders for consumer durables, which include washing machines, cars and airplanes, rose 1.1 percent from the previous month, beating economists’ expectations for a 1 percent decline.

Developments in the US debt ceiling talks also pushed US yields higher as White House negotiators look to reach a deal with the Republican leadership of the House of Representatives over the weekend.

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European and UK yields also rose.

The yield on two-year British debt jumped 0.6 percentage point to above 4.5 percent this week, the highest level since October. The equivalent German bond yield fell from around 2.5 percent at the beginning of the month to barely 3 percent.

Investors were particularly unsettled by high core inflation – a measure that strips out volatile food and energy prices – which is putting pressure on central banks to raise interest rates further even with the risk of a recession.

“We’re certainly not out of the danger zone,” said Sonja Laud, chief investment officer at Legal & General Investment Management.

Analysts at BlackRock recently said that most advanced economies “have a common problem. . . Core inflation is proving to be more stubborn than expected and remains well above the central banks’ 2 percent target”.

“We believe this means that central banks will not be able to withdraw inflation-fighting rate hikes any time soon,” they wrote.

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Earlier this month, markets priced in another interest rate hike by the European Central Bank to 3.5 percent, but futures markets now expect rates to peak at 3.7 percent by October.

“Europe has practically lagged behind the USA in the economic cycle, so we think that the ECB has moved on.” [rate increases] to go,” said Mark Dowding, chief investment officer at BlueBay Asset Management.

In the UK, data released this week showed that core inflation rose 6.8 percent 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. Swap markets are pricing the Bank of England’s top rate for November as high as 5.5 percent, up from 4.9 percent a week ago, well above the current 4.5 percent.