One of the key themes in the market so far this year has been investors’ acceptance that Treasury yields could stay low for some time. Hence Treasury yields, although they have picked up this week, remain close 2.48%, the lowest level since summer 2013.
But is this justified? Although the US economy struggled at the start of this year it is getting its groove back and the labour market, in particular, is showing signs of strength. In our view, the US economic recovery is taking hold, and if the Fed is not careful it could end up stoking inflation, which, as we will show below, could have major ramifications for the bond and FX markets.
The chart below shows core PCE, the Fed’s preferred measure of inflation, going back to the 1960’s. The current movement in PCE looks similar to the price action in the 1960’S. Back then core PCE made a double bottom before shooting higher, eventually reaching a peak of nearly 10% in 1974. From 1960-61 there was a sharp fall in inflation in the US, Inflation then traded sideways before accelerating from 1.8% to 3.15% in a mere 8 months between 1966-67.
Fast-forward to today and we have seen a sharp fall in prices since the 2008 financial crisis, followed by a period of consolidation for the past year, where prices have moved in a tight range between 1.1% and 1.21%, as you can see below.
Figure 1: 
Source: FOREX.com and Bloomberg
Both the technical backdrop and the fundamentals suggest that there is a chance that inflation could break out to the upside sooner than some people expect. Upward price pressures are already starting to mount in food, energy and owners’ equivalent rent prices, so it could be a matter of time before this feeds through to the headline data.
If this happens then it could have big ramifications for the bond and FX markets. The chart below shows US Treasury yields and core PCE. These two have a close positive relationship, so if core PCE breaks to the upside, then we could see Treasury yields come under upward pressure at the same time.
Figure 2: 
Source: FOREX.com and Bloomberg
What does this mean for the Dollar? Take a look at the chart below, which shows the spread between U.S. and Japanese 10-year yields and also USD/JPY. These two have a close relationship, and where the yield spread goes, USD/JPY tends to follow.
To conclude, core PCE may be the data point to watch for the US in the coming months. If (or when) core PCE starts to break out then it could trigger fireworks for bond and FX markets.
Figure 3:
Source: FOREX.com and Bloomberg