Policy signals shape the rates outlook

Key takeaways

• Treasury buybacks signal sensitivity to elevated long-term yields
• Higher UK inflation largely reflects rising energy costs
• Bank of England rate expectations may be too high

The U.S. Treasury announced that, from September, it will at least double purchases of Treasuries in the 10-to-20-year and 20-to-30-year maturity sectors, from $2 billion per operation to $4 billion or more. The increase will run through the next Quarterly Refunding Announcement in early November.

The announcement provided some relief for long-end yields, which had been under pressure since the last Federal Open Market Committee meeting. Both thirty-year Treasury yields and the U.S. Dollar fell on the day, while gold rallied.

The signal may be more significant than the size of the purchases themselves. The move provides another indication of the U.S. administration’s sensitivity to elevated bond yields, following earlier policy adjustments after Liberation Day and recent coordination with Japan around the yen.

Still, this is not quantitative easing or yield curve control. The Treasury is buying less-liquid, longer-maturity bonds and effectively funding those purchases through short-term bills. The approach has some similarities to the Fed’s Operation Twist in 2011, although the scale is an order of magnitude smaller. Ultimately, the economic outlook should remain the primary driver of long-term yields.

UK headline CPI rose to 2.9% year-on-year, broadly in line with expectations. Much of the increase reflects the higher energy price cap feeding into household bills rather than renewed acceleration in underlying inflation.

Services inflation, which has been a persistent concern for the Bank of England, continues to decelerate. Headline inflation could rise further through the rest of the year as higher energy costs feed into the data, making the next few readings potentially uncomfortable.

For the Bank of England, the question is whether higher energy prices pass through to wages and broader domestic price pressures. So far, there is limited evidence of those second-round effects.

This week’s employment report was also a touch soft. Wage growth was slightly stronger than expected, but the broader trend suggests the labour market is considerably less tight than it was a few years ago.

The inflation and labour market data do not materially change the outlook for the Bank of England. Despite risks from higher and more volatile energy prices, the 40 to 50 basis points of hikes currently priced over the next year still appear too high, given limited evidence of second-round inflationary effects.

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