EUR, US curve steepening to persist on inflation, pre-emptive Fed easing bets

Investing.com -- Bond markets are back in the spotlight as UBS is betting the steepening of both U.S. and euro curves will continue, driven by sticky U.S. inflation, talk of pre-emptive Fed easing, and renewed focus on Ukraine risks.

While a wave of volatility at the short end of the yield curve could trigger some bear flattening, the house view is clear: “We expect our US 5s30s steepener and EUR 10s30s steepener to keep performing.”

A Steeper Slope as Inflation Surprises

UBS warns that upside inflation surprises and nagging uncertainty over trends are forcing investors to demand higher yields on longer-dated bonds. July’s U.S. inflation delivered less tariff punch on goods, but "the upside surprise in core inflation led to steepening in both the US and German curves." With services inflation now flagged in client discussions as the next hot theme, the risk is a further acceleration unless seasonal quirks fade out.

Former Fed vice chair Alan Detmeister has suggested that “core CPI services price changes were pretty close to the pre-pandemic range in each of the past 5 months if you look at non-seasonally adjusted changes,” but UBS isn’t calling for the trend to vanish. Their base case remains that U.S. CPI inflation peaks above 3.5% before any real relief is seen.

Is the Fed Rethinking Easing?

Duration investors burned in 2021 to 22 might not wait patiently for the inflation target to come back into view. The report flags Treasury Secretary Bessent’s push for a “monetary policy strategy based on pre-emptive easing,” rather than the current status quo of data dependence which could see rates fall at least 150bps. UBS highlights the lessons from the Greenspan era, when the Fed eased despite sticky inflation and was later credited for the “perfect soft landing.”

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Across the Atlantic, the possibility of a Ukraine ceasefire and lower gas prices could fuel euro growth. This could, however, also slash already weak inflation forecasts. UBS’s baseline sees German deficits rising and “term premia until there is more clarity on the cost of the reconstruction of Ukraine."

History suggests that bund investors may stay nervous until the costs of conflict and reconstruction come into focus.

Even if the outlook for energy prices in Germany and other euro area countries remains unclear, bond bulls will have to continue their wait for a pivot as steepening risk is expected to the core story for now as inflaiton, policy, and global headlines send ripples through rates strategy, UBS said.

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