Something Realy Strange Just Happened to Interest Rates

Treasury yields have finally made a sizable move upward with the two-year hitting multi-month highs and the ten-year yesterday reaching $4.70. So naturally the question comes up, is the bond market finally starting to reprice inflation and do so in a serious way? Or is this another one of those hurricane warnings where everyone overreacts to all the headlines, panics for five minutes, and then really misses what the curve is actually saying, or should I say curves? There is a lot going on in money and rate markets that no one recognizes. We've got bill rates going down, front forward rates backing them up, and doing something completely unexpected. You've got tips being conclusive along with the frowny forward rate curve leaving no doubt about what's really going on here. Because yes, yields are higher at the long end, oil is higher, gasoline is heading toward painful levels, we all know that. And those are going to have an impact on consumer prices. Central bankers are already getting itchy. You can almost hear the hawks whispering, remember Volcker, in the hallways. But the bond market is saying something far more specific. It's what you need to know about what's going on with interest rates. Today we're going to walk through the evidence. We'll start with oil because that's the spark. Then we'll look at tips, break-evens, including some basics about how that market works. Because you need to know what these indications are indicating. And after that, we'll check in with treasury bills, term SOFR, and yes, term SOFR futures. And I'll make sense of what all of those are and what they're saying. We've also got CPI data from places like Canada and the UK, which shocks central bankers in the mainstream, but are perfectly consistent with everything that we're going to go over here. Everybody's talking about how this is the market preparing for Volcker, when the curves, multiple curves, are instead showing you what's happening is the market is looking at another central bank figure in inflation and rate hike hawking lore. So we've got to start with crude oil. WTI futures, they remain under pressure, though the shape of the futures curve there hasn't changed all that much recently. The June contract is technically still a front month, at least it was yesterday, though it's leaving the board and it's thinly traded. So for practical purposes, July is already the real front contract. The prompt spread has eased a little bit, but the July to August spread is still about $5. The three month spread remains very wide, around $13 to $14, depending on which contracts you're using at this moment in time. And that matters because the oil futures curve, it's still telling us the same basic story. The market is under stress, especially in the near term. There had been some hope that the oil situation would be moving toward resolution by now. That was especially true when the ceasefire was first announced last month. But as direct confrontation gave way to the economic blockade, it became increasingly clear that neither side is going to be backing down. So the market has had to adjust and so perceptions have had to adjust. The front end of the oil curve still reflects the tight supply and strong demand for immediate delivery. But the contracts further down the curve have also crept a bit higher, beginning to look like a longer lasting energy problem. And that matters for perceptions and prices, not necessarily inflation itself. We'll get into that distinction, but inflation data. If oil stays elevated, gasoline follows. If gasoline keeps rising, headline CPIs are going to go up. And if headline CPIs go up for three or four months in a row, central bankers start sweating through their suits, their empty suits. They see gasoline near $5, they see consumers getting angry, they see headline CPIs accelerating, and they immediately start worrying about inflation expectations. The market understands that, but understanding that central bankers may panic over headlines is not the same thing as expecting an inflation, a genuinely inflationary breakout. And that is where the tips market and breakevens come into this. Before we go on with our video today, let me ask you a question. What if your gold could actually pay you every single month in more gold? That's what today's video sponsor, Monetary Metals, lets you do. And here's how it works. You still own the gold, it's still in your name, it's fully insured. But instead of just sitting there doing nothing, it actually starts working for you. Monetary Metals has built a system that turns idle gold into productive gold. Earning real yield, paid in physical gold, not dollars. No selling, no trading, no converting. You keep your gold and every month you get more of it. It's a simple idea, but it solves a big problem. If gold is money, it should act like money. And now it finally can. If you're a long-term gold holder looking for a smarter way to store value, check them out at monetary-metals.com slash Snyder. Again, that's monetary-metals.com slash Snyder. I highly recommend booking a call with them today to see if they're the right fit for you. We thank Monetary Metals for their sponsorship, but now let's get back to the rest of our video. Now before we use TIPS to answer the inflation question, let's quickly explain what these break-even rates are. TIPS are Treasury Inflation Protected Securities. And unlike regular Treasury bonds, where the principal gets fixed, the principal value of a TIPS bond adjusts with CPI changes. So a regular Treasury pays you a nominal yield. A TIPS bond pays you a real yield plus compensation through principal adjustment if the CPI rises. And the difference between the nominal Treasury yield and the TIPS real yield is called the break-even inflation rate. That's what we're going to focus on. For example, if the 10-year Treasury yield is 4.7%, like it was at times yesterday, and the 10-year TIPS real yield is 2.25%, then the 10-year break-even rate is 245 basis points. In very simple terms, that means CPI inflation would need to average roughly 2.45% over that period for TIPS and regular Treasuries to break even against each other. Though we've got to be careful here because we don't want to take break-evens literally. There's a bit more math and a little bit more assumptions and processing that goes into making up break-even rates. But the way to think about break-evens is about how willing the Treasury market is to buy that CPI protection that's paid to them by the Treasury Department. If inflation ends up higher during the life of the TIPS bond than the break-even, the TIPS are going to outperform. So if you think the CPI is going to be higher, you'd be willing to buy a TIPS bond because you think you'll end up being paid more in protection yield from the government than the break-even rate implies. The more investors who think like you do, the lower the real rate goes and the higher the break-even. It tells you about demand for inflation protection. It shows you just how much there is across the market. When break-even rates are rising strongly, that indicates more expectations for higher CPIs over the bond's term. So we can compare break-even rates at different maturities, too. They give us a sense of the market's position on roughly when investors are seeing inflation potential. Investors that are expecting a major inflation breakout will be buying protection at increasing demand. So short-run break-evens would rise strongly, but they would be matched and even exceeded by longer-term break-evens as the market scrambles to find longer-lasting inflation hedging. If, however, break-even rates are higher for shorter-term instruments than their longer-run counterparts, which really shouldn't happen, that means investors are buying protection only for a short-run burst of higher CPIs, a transitory shock. Now, this is very important. Break-evens are not a perfect forecast of inflation. They are influenced by liquidity, risk premiums, supply and demand in the TIPS market, seasonal CPI effects, and some other technical factors. So we should never treat a break-even rate as a precise prediction. They are extremely useful for relative analysis. So you ask yourself, are break-evens rising sharply? Is the front end rising more than the long end? Is the entire break-even curve steepening? Are longer-term forwards moving higher? Those are the clues that tell us whether the market sees a temporary CPI bump or a broader sustained inflation problem. And right now, the answer is not just obvious, it is conclusive. The TIPS market is not pricing a breakout in inflation. It is instead pricing a classic energy shock case. Even though the five-year break-even rate did hit a multi-year high this week, this past week, last couple of days. So even though five-year break-evens and ten-year break-evens are up, you have to put them into the broader context. So when the five-year hit 270 basis points, at first glance, that sounds serious. You know, it's a multi-year high. But under the current circumstances, it's actually underwhelming. Think about it. Gasoline is moving toward five bucks. Oil is over $100. Energy markets are completely disrupted. If the market genuinely believed this was turning into a broad-based sustained inflation, five-year break-evens should be exploding higher, similar to what they had done in 2022. But as you can see, they're not. The last time retail gasoline was in this general vicinity, five-year break-evens were more like 325 to 350 basis points. That's an enormous difference. Why? Because back in 2022, when that happened, the market was dealing with much broader supply shock. Prices were rising across multiple categories. Goods, shipping, labor, energy, food. It was everywhere. Today's version is far narrower. It's only oil. It's only gasoline. It's just energy. And the TIPS market is very clear about this. The energy shock can absolutely push this headline CPI rate higher in the short run, but that's not the same thing as inflation becoming embedded across the entire economy, or even just the broad-based supply shock like four years ago. Break-evens are nowhere near that. The 10-year break-even, as I mentioned, that's already moved up too, and it hit a multi-year high. But even there, the message is not runaway inflation. The back end is being pulled upward mechanically because near-term CPI payments are expected to be higher. That's the short run. If gasoline spikes, TIPS holders receive more CPI protection in the near-term months. That matters for all TIPS maturities, but it matters more for shorter-duration ones, higher break-evens for those. That's why the curve shape is so important here. If this was genuine inflation risk, you would expect longer-term break-evens and forward inflation measures to move aggressively higher. You would expect the market to price persistent inflation, not just some temporary CPI noise. But that is not what's happening. The 5-year, 10-year break-even spread remains heavily inverted. And then the longer-run forward measures, like the 5-year, 5-year forward rate, they have moved off their lows, but remain well within the recent range. In very plain English, the market sees higher CPIs in the near-term because of energy, but it does not see that turning into sustained inflation regime. It doesn't even see energy prices being pushed into broader consumer prices in the short run. These are critical distinctions. Oil prices can soar ahead, gasoline can crush consumers, and headline CPI rates can remain uncomfortably high for central bankers for a couple of months. But none of that yields actual genuine inflation. And the TIPS market is absolutely conclusive about what's happening or what's priced to happen in the near-term and then beyond it. We've got a couple of real-world useful examples, too, from Canada's CPI as well as the UK. Now, when energy prices rise, headline inflation can move up quickly. We're already seeing that take place. It's not complicated. Gasoline is a highly visible price. It changes fast, and consumers, they can feel it immediately. But the real question is not whether headline CPI rates rise. Of course they do. The real question is whether the pressure spreads. Are core measures accelerating in a way that suggest a broadening impact beyond the energy components? Are services prices, for example, are they taking off? Are consumers pulling forward demand because they expect prices to keep rising? We're not just talking about energy and gasoline. That's the story central bankers are afraid of. That's the expectations theory nightmare. Now, setting aside how the theory is garbage and has never been once validated, the evidence that we have still looks much more like the classic energy shock than a self-reinforcing inflation cycle. Canada's numbers, they fit that broader picture. And so do the latest ones from the UK where the Bank of England is leading the charge toward rate hikes in both places. The headline rates were even well below expectations. And they were pushed around almost entirely by fuel costs alone. Core rates in Canada, they actually hit cycle lows. And the one for the UK decelerated. The opposite of what should be happening if central bankers and their concerns were correct about something for once. So this is where they often get into trouble, officials. They see the headline, they react to the headline, they talk tough because the headline looks bad, especially if it goes on for more than a few months. But markets are usually asking the deeper question. Is this inflation or is this just an oil shock that damages growth? Those two things are not the same. And Canada's CPI, like the UK's, especially their core rates, are showing you exactly what we're seeing in the TIPS markets as well as the rest of our indicators, the rest of our money market and rate indicators. So let's move from the inflation compensation of TIPS to shorter-term rates. And as I said in the intro, this part of the market is doing the opposite of what you'd expect and think. If markets were truly pricing a near-term rate hiking cycle, we should see it very clearly in Treasury bills and short-rate markets. But that's not what we're seeing either. The four-week bill yield has dropped back toward the mid-360s. Bills out to around four months are seeing bidding interest. Even the six-month bill is barely a couple basis points higher than it had been. That's not what you'd expect to see if real money investors were aggressively positioning for imminent rate hikes out of the Fed. If anything, the very front end is moving the other way. And term SOFR tells a very similar story, though this one can get tricky and confusing. Term SOFR is a little technical. So here's the short version. SOFR itself is an overnight secured funding rate. And unlike old LIBOR, it doesn't naturally have a term structure, which is one huge reason why SOFR sucks, especially compared to the old LIBOR. And it's far from the only reason. So markets use futures and related instruments to infer forward-looking SOFR rates. And what have those implied term SOFR rates been doing? Well, take a look at yourself. They've been drifting lower. Not crashing, not wildly moving, but steadily declining since late March, persistently. And that matters. Because while everyone is focused on the 2-year and the 10-year moving higher, the very front end of the money market and the rates market is not screaming rate hikes now. The market sees central bankers getting more nervous. It sees the hawks growing louder. It knows gasoline will put pressure on political and policy conversations. But so far, the short-rate market is not convinced that the energy shock is enough to force an immediate rate hike move. And that is a huge deal. So let's come back now to the Treasury curve. Yes, yields have moved higher. The 2-year, as I said, multi-month highs. The 10-year reached 470. But the composition of the yield curve and interest rates and maturities, that matters as much as the nominal levels. If this were a true inflationary breakout, we would expect to see a more powerful drive in longer-term inflation compensation. We went over that part. We'd also expect the long end to reprice a durable inflation premium. We would expect a clean steepening consistent with nominal growth and inflation risk. Instead, the 2-year is doing most of the work. The curve has flattened, but it wasn't all that steep to begin with. It's flattening from an already historically flat shape. And that tells us this is still primarily about the possible future over-the-horizon risk of Casey, Jeff, and Cleveland, Beth getting too full of themselves. Maybe the new guy, Warsh, too. The market is not saying, here comes a decade of inflation. What it is saying is that energy prices may eventually, eventually pressure central banks into sounding or even acting more hawkish, even if the underlying economy can't really handle anything. That's why this move higher in yields has to be read alongside tips, bills, and terms SOFR. And as we'll see, terms SOFR futures, which make it conclusive. Nominal treasury yields alone, they can be somewhat misleading. And we've seen this before. Look back to early 2024, right after the bond rally first began. For a period of four plus months, the two-year treasury yield jumped by 90 basis points. 90. That's even more than the current rise. And why did that happen? Well, oil prices, for one. Jay Powell at the time was worried about how those might lead to sticky inflation and therefore higher for longer policy rates. The market disagreed. And that's why the curve behaved the same way it's behaving right now. And tips did the same thing, too. But the market also has to account for just how irrational central bankers can be. Even if there isn't an imminent rate hike threat, by their rhetoric and irrationality, officials can put uncertainty into the yield curve over the horizon, which is reflected in rising nominal rates beyond the bills. The yield curve is rising not because of inflation or even expectations for something like that. It's knowing that there's a serious chance central bankers, including those at the Fed, will trichet themselves. And by the way, Jean-Claude Trichet is the guy who raised rates twice. Once during the middle of the 2008 crisis and then again two more times in 2011 in the middle of that one. And if central bankers like Trichet are crazy enough to raise rates at times like those, they can do anything, no matter how wrong and stupid. That's why yields are rising right now. And when looking at the rest of the curves, you clearly see that's the only reason they're going up. So if you wanted full and complete confirmation, this is about the Fed and Fed policy and risks to them, the uncertainty created by these people, term SOFR futures leave absolutely no doubt. Just like Tip said, there's no doubt about lack of inflation risk. Term SOFR futures say there's no doubt about where this threat is coming from. It's not inflation. It's the misinterpretation of inflation from central bankers, therefore central bank policies. These are the forward rate contracts that are used to create the term SOFR rates that we went over earlier. Basically, they tell us what the market thinks about the probable path for short-term interest rates, which means a lot about what the Fed's policy path might look like. And the curve has developed what I like to call the frown. And the frown has two parts. First, rates rise in the near term because markets assign some probability that central bankers are going to get spooked by oil and gasoline. And second part of that frown, rates fall later because doing that would be an utter mistake because the energy shock itself was more likely to damage demand enough to force rate cuts down the road. So the curve slopes up, then it slopes down. That's the frown. Before the energy shock showed up, SOFR futures were still sharply inverted. The market was already worried about growth, about credit and the possibility the Fed would eventually be forced to cut rates substantially in 2026. But then oil surged. And the front part of the SOFR futures curve lifted because markets knew the longer the energy shock drags on, the greater the chance central bankers won't be able to resist tricheting themselves. That's why bill yields aren't going up. The market isn't seeing this as something which happened over the next couple months. But if gas is still five bucks and rising with the headline CPI rates in the threes by July or maybe August, then the trichet possibility goes way up. And it shows. It shows directly in terms SOFR futures just like the two-year cash UST. Not because the market suddenly believes in runaway inflation, because the market believes policymakers might. That distinction is everything. In other words, the more oil rises, the more the market thinks that they're going to want to act like Volcker. But the market also knows that they won't be Volcker. They'll end up being trichet. So rates might go up in the short run, which creates a bunch of uncertainty and therefore higher rising nominal yields. Not inflation expectations, not imminent rate hike expectations, but the potential, the longer the energy shock goes, the more possibility that central bankers will trichet themselves. So is the bond market repricing legitimate inflation risk? The evidence says conclusively no. Oil is higher. Gasoline is getting more painful. Headline CPIs, they're likely to be stronger in the near term. We've seen that in Canada, the UK, already in the United States. And central bankers are absolutely becoming more uncomfortable. But tips break evens are not confirming broad inflation. Longer term inflation forwards are not breaking out. Bills are not pricing immediate rate hikes. Term SOFR has been drifting lower. When you put all these pieces together, the conclusion is surprisingly uniform, at least surprising to people who don't pay attention to all the curves that they need to. The market is not screaming 1970s inflation. It's saying oil and gasoline may push CPIs higher in the short run. It's saying central bankers may get more hawkish because they can't resist reacting to the headlines. But it's also saying the energy shock is far more likely to damage demand than create some kind of sustained inflation. In other words, this isn't the bond market confirming an inflation breakout. It's the bond market seeing a classic energy shock case and how central bankers are just itching to trichet themselves. It's looking at a policy mistake and that's why all the curves are frowning. And of course, this is a global thing, not just U.S. dollars and U.S. rates. I went over some of those implications as they relate to China and the ugliness there. Video link below. As always, thank you very much for joining me. Huge thank you, Eurodollar University members and subscribers. And until next time, take care.