The return of premium on term limits has pushed up real interest rates! Dangerous signals are emerging in the U.S. bond market, and the July CPI will serve as a stress test.

The Federal Reserve's reluctance to raise interest rates and its lack of forward guidance are having a cascading effect on the market, pushing both nominal and real interest rates higher and resulting in a steepening of the U.S. Treasury yield curve. Although this impact has not yet become apparent from a historical perspective, its effect on risk assets will eventually surface as real yields rise. Currently, the increase in real yields may not be significant enough to create a substantial impact. Therefore, the U.S. Consumer Price Index (CPI) report for July, due to be released this week, may serve as a kind of "stress test." This report will come after a weak non-farm payroll report, which did not lead to a noticeable decline in the yields of 10-year and 30-year U.S. Treasuries. The market's reaction to the CPI data could convey clearer information. At present, the market expects that the July CPI report will not indicate runaway inflation. Analysts forecast a 0.1% month-over-month increase in the overall CPI, up from June's 0.4% decline; the year-over-year growth rate is expected to be 3.4%, slightly below June's 3.5%. The core CPI, which excludes food and energy prices, is anticipated to rise by 0.2% month-over-month, compared to June's flat performance; the year-over-year growth rate is projected to be 2.5%, down from June's 2.6%. However, predictive platforms like Kalshi, based on market trading, indicate that the July CPI is expected to increase by 0.1% month-over-month and 3.3% year-over-year; the core CPI is anticipated to rise by 0.2% month-over-month and 2.4% year-over-year. At the same time, current pricing in CPI swap contracts suggests that the overall CPI year-over-year growth rate is expected to be 3.4%. Thus, on the surface, Kalshi's predictions seem to imply that the month-over-month CPI data will meet expectations, but the year-over-year data may fall short of the market forecast. The insights from Kalshi's predictive results may carry more significant implications for market transmission because they could generate more pronounced market effects. One possible scenario is that even if the year-over-year CPI data disappoints, it may not necessarily lead to a marked change in the direction of long-term interest rates, similar to the market's reaction following the earlier non-farm payroll report. It is not just inflation driving rates higher Currently, inflation expectations might be one factor contributing to rising interest rates, but they are not the sole factor. In fact, looking at the 10-year breakeven inflation rate, inflation has actually declined since mid-May, while the 10-year Treasury yield has continued to rise. This indicates that real rates are trending upward. At the same time, this breaks the previous cycle where nominal rates and inflation expectations moved in sync. This suggests that other factors may currently be pushing rates higher, and inflation is not the only driver. One obvious factor appears to be the term premium, which is the additional compensation investors demand for holding U.S. Treasuries. In fact, the current 10-year real yield has exceeded the 10-year breakeven inflation rate. This marks the first such occurrence since the 2008 financial crisis, with the previous instance being in 2007. This is a significant shift and may suggest that the market is regaining control over the inflation narrative, pushing long-term rates to sufficiently high levels to address issues that the market believes the Federal Reserve is reluctant to tackle proactively. The gap between real rates and inflation expectations crossed and reversed on June 22. This timing coincided with the June Federal Open Market Committee (FOMC) meeting, as well as Kevin Walsh's first press conference, and the Fed's removal of forward guidance. If the market is re-entering an "anti-inflation" mode, then as real rates rise, breakeven inflation rates could still decline further. If the 10-year real yield rises another 25 basis points, the breakeven inflation rate will drop to 2%. This level has fluctuated around 2% for years and coincides with the inflation target set by the Federal Reserve. Broader market implications Typically, rising real yields are thought to pose a negative impact on risk assets, as historical experience supports this notion. It is possible that real yields have simply not risen enough to break the upward trend of risk assets. Historically, when the market reached turning points, real yields often peaked at different levels: during the late 1990s, the 10-year real yield reached 4%, ultimately bursting the dot-com bubble; in 2007, real yields approached 3%, leading to the collapse of the housing bubble; in 2018, real yields reached around 1%, resulting in a significant market drop at year-end; and in 2021, real yields climbed to about 1.7%, triggering market adjustments. It is currently difficult to identify a specific critical point. However, considering the ongoing rise in real yields, it may take real yields approaching 2.7% to 3% to create a genuine impact on the current AI bubble. Another possibility is that real yields remain too low at present, and thus have yet to produce an adequately large effect. This is due to the current spread between the S&P 500 index's earnings yield over the next 12 months (NTM) and the 10-year Treasury Inflation-Protected Securities (TIPS) rate, which is only 2.6%. Before the bursting of the 2000 dot-com bubble, this spread actually fell into negative territory. The significance of the July CPI report Therefore, the July CPI report offers an important opportunity for market observation. More significant outcomes to watch for are not when CPI exceeds expectations, but rather how bond yields react if CPI falls short of expectations. If bond yields still refuse to decline amidst a notably weak non-farm employment data and a lower-than-expected CPI, this information may prove more valuable than any instance of inflation data exceeding forecasts. This also serves as a reminder to market participants: there is always undiscovered information within the market, even if it is not always obvious.