The current up move in bond yields globally is driven by term premium, higher rate expectations, breakeven inflation & higher real rates. But what we find surprising is that the rise in bond yields has been largely associated with relatively low levels of realized and implied volatility and only modest tightening in financial conditions. This points to two ongoing risks for rates markets. First, the renewed energy pressures force central banks to choose whether to lean against inflation or not. Second, the current benign signals from financial conditions suggests reduced confidence in just how restrictive policy rates currently are. More over the increased uncertainty over terminal rates is adding to global flattening bias. But using monetary policy to affect inflation outcomes may afford relative stability to longer-dated forwards though it brings risks of upsetting the comparatively benign vol backdrop. At current levels, we think that it will be hard for longer-term yields to fall sharply via lower risk premia alone under most scenarios, however, leaving lower yields up to better inflation news or a worsening cyclical view—both of which should result in a larger move lower in front-end/belly yields. With the US curve already relatively flat against front-end steepness, combined with the resilient growth backdrop, we think that the US curve should be biased steeper relative other markets such as Europe and Australia where policy is more front footed. While periods of higher private sector borrowing coincide with a greater tendency for yields to meaningfully overshoot fair value, dislocations have been contained this year as the rise in yields has been mostly justified by fundamental drivers. So if only fundamentals were driving current uptick in bond yields, then current levels are more or less the top. But uptick in IG bond supply might be the next trigger through the macro channel route. Hence current bond yield rally is not yet transitory.
