Investors expect higher interest rates as inflationary pressures mount

Stronger-than-expected US inflation and increased consumer spending have fueled global expectations that interest rates will rise, as predictions about future monetary policy change rapidly.

The Federal Reserve’s preferred measure of inflation beat expectations in April, data released on Friday showed, while US consumer spending rose last month and new orders for durable goods rose unexpectedly.

Kristalina Georgieva, head of the IMF, warned on Friday that US interest rates would have to stay higher for longer to rein in inflation that had been more persistent than expected. She added that a loss of confidence in the US Treasury markets would spell turmoil for the global economy.

Short-term government bond yields in the US, UK and eurozone have started to rise again as investors shift from betting on an economic slowdown to anticipating longer rate hikes to deal with price increases.

The change in rate expectations marks a big shift for fund managers and traders, who have spent much of the year trying to predict when central banks will start cutting interest rates.

Futures markets are now pricing in a 37 percent chance that the Fed will raise interest rates again in June, having previously anticipated that the next move would be a cut.

The yield on two-year Treasury notes, particularly sensitive to investors’ interest rate expectations, rose to 4.6 percent from a low of 3.7 percent earlier this month. Yields rise when prices fall.

Adding to signs that the US economy is still advancing, inflation-adjusted personal consumption rose 0.5% in April from a flat reading in March as spending on services such as insurance and medical attention.

“We continue to be surprised by the rising inflation data and that is a problem,” said Florian Ielpo, head of macro at Lombard Odier Investment Managers.

Orders for durable goods, which include washing machines, cars and planes, rose 1.1 percent from the previous month, above economists’ expectations for a 1 percent drop.

Developments in the US debt ceiling negotiations have also pushed US yields higher as White House negotiators look to reach a deal with House Republican leaders this weekend .

European and British yields have also increased. The UK’s two-year bond yield jumped as much as 0.6 percentage point this week to more than 4.5 percent, its highest level since October. The equivalent yield on German bonds has risen from around 2.5 percent earlier this month to just under 3 percent.

Investors have been particularly unsettled by high core inflation, a move that stamps out volatile food and energy prices, which puts pressure on central banks to raise rates further, even at the risk of recession.

“We are definitely not out of the danger zone yet,” said Sonja Laud, chief investment officer at Legal & General Investment Management.

In a recent note, BlackRock analysts said that most developed economies “are grappling with a shared problem. . . Core inflation is proving more stubborn than expected and remains well above central banks’ 2 percent targets.

“We think that means central banks cannot undo any of their inflation-fighting rate hikes anytime soon,” they wrote.

Earlier this month, markets had priced in a further rate hike by the European Central Bank to 3.5%, but futures markets now expect the rate to peak at 3.7% in October.

“Europe is effectively just behind where the US is in the business cycle, so we think the ECB has more [rate increases] takeaway,” said Mark Dowding, chief investment officer at BlueBay Asset Management.

In the UK, data released this week showed core inflation rose 6.8 percent in the year to April, faster than economists had forecast.

Imogen Bachra, head of UK rate strategy at NatWest, called the figures a “game changer” for interest rates. Swap markets are trading at a top Bank of England rate of up to 5.5 percent in November, up from 4.9 percent a week ago, much higher than the current 4.5 percent.