ORLANDO, Florida, May 15 (Reuters) - TRADING DAY

Making sense of the forces driving global markets

By Jamie McGeever, Markets Columnist

Softer bond yields cushion stocks

Cooler inflation pressures in the shape of surprisingly soft

U.S. economic data and a slide in oil prices helped bring down

Treasury yields and support stocks on Thursday, although the

recent surge on Wall Street does appear to be losing steam.

In my column today I look at how the decline in U.S.

inflation - a healthy development, in most people's eyes - is

coming with an unwelcome side effect - rising real yields. More

on that below, but first, a roundup of the main market moves.

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If you have more time to read, here are a few articles I

recommend to help you make sense of what happened in markets

today.

1. Trump promises to strengthen ties with United

Arab

Emirates on Gulf tour

2. Fed policymakers on hold to seek clarity from the

data,

but the data are not cooperating

3. APEC warns of stalling trade due to tariffs as

China, US

officials meet

4. UK economy has a growth spurt before tax and

tariff

challenges

5. Republicans embrace Trump's populist tax push

with

midterms in mind

Today's Key Market Moves

* The Dow is the best performer of Wall Street's three main

indices, rising 0.65%. It's now right around the 200-day moving

average of 42289 points.

* The VIX volatility index closes at 17.81, its lowest

closing

level since March 25.

* Walmart shares fall as much as 5% after the

retailer

warns on the outlook, but end the day only 0.5% lower.

* Oil falls 2.5% on expectations for a U.S.-Iran

nuclear

deal, which could ease sanctions and free up more supply.

* The yen is the big gainer in G10 FX, rising around 0.8%

against

the dollar ahead of Japan's Q1 GDP data on Friday.

* South Korea's won rallies after a government official says

the

deputy finance minister met with a senior U.S. Treasury official

on May 5 to discuss the dollar/won market.

* Gold hits a one-month low of $3,120/oz before

rebounding

to close at the day's high, up nearly 2% at $3,235/oz.

Inflation - calm before the storm?

A decline in European and U.S. bond yields provided the

springboard for equity markets on Thursday. Or at least a

cushion.

Thursday's U.S. bond market rally will also have come as

relief to policymakers in Washington as yields pulled back

sharply across the curve, but not before longer-dated yields hit

fresh one-month highs. The 10-year yield hit 4.55% and the

30-year yield reached 5.00% before sliding back.

The recovery in global stock prices since the 'Liberation

Day' tariff debacle early last month has been impressive, but

understandably, that momentum is fading. For that momentum to be

rekindled, a further decline in bond yields may be required.

Although figures this week showed U.S. consumer and producer

inflation cooled in April, tariffs have yet to bite and price

pressures are tilted to the upside.

Worries about the U.S. public finances are intensifying too.

The Trump administration's plans to extend tax cuts, coupled

with what many analysts consider to be a lack of commitment to

reduce spending, will widen the budget deficit, perhaps to more

than 7% of GDP.

Add to that the apparent desire among foreign investors to

reduce their exposure to U.S. assets, and Treasuries' safe haven

allure has been diminished. Just when the deficit is widening.

All of this means the 'term premium' - the extra

compensation investors demand to hold longer maturity Treasuries

rather than rolling over short-dated ones - is near the highest

in over a decade. The yields on 10- and 30-year bonds are now

not too far away from levels that were the norm before the

Global Financial Crisis.

Previous spikes in the term premium have cheapened bond

prices sufficiently to attract overseas money back into the

market, especially the 7-10 year part of the Treasury curve,

says Bank of New York's John Velis. But this hasn't happened

this time around, suggesting yields may have further to rise.

It's notable that the 30-year yield fell only 5 basis points

on Thursday, 3-4 basis points less than any other point on the

curve.

Meanwhile, the main focus for investors in Asia on Friday

will be Japan's first quarter GDP figures. Economists polled by

Reuters expect an annualized contraction of 0.2%, which would be

a significant drop from the 2.2% expansion the previous quarter

and the first in a year.

These are backward-looking numbers but the immediate outlook

is highly uncertain, at best - the tariff turbulence has put the

yen back under pressure and has, according to many analysts, put

the Bank of Japan's rate-hiking cycle on ice.

US inflation progress stokes real yield problem

Few would find fault with the steady, gradual decline in

U.S. inflation, but it has recently come with an unwelcome side

effect: rising 'real' borrowing costs.

With the Federal Reserve's official policy rate on hold and

the benchmark 10-year Treasury yield edging higher,

inflation-adjusted interest rates - so-called real rates - are

rising, effectively tightening monetary policy and financial

conditions.

The real yield on the 10-year Treasury note is now

approaching 2.20%, the highest in a decade, based on the April

headline annual CPI inflation rate of 2.3%. And the real fed

funds rate has risen from a low of 1.50% in January to eclipse

2.00%, the highest in more than six months.

While real borrowing costs are not at levels that will

trigger alarm bells with Fed officials, CEOs or CIOs, the

direction of travel is pretty clear, and is one more factor that

could weigh on the activity of consumers, businesses, and

investors in an environment already shrouded in a thick fog of

uncertainty. Additionally, for policymakers, it shines a light

on the constant struggle to determine the optimal interest rate

at any given time.

In Fed Chair Jerome Powell's press conference earlier this

month after the central bank left its fed funds target range on

hold at 4.25-4.50%, he said no fewer than eight times that rates

are "in a good place". Current policy is "somewhat" and

"modestly or moderately" restrictive, he added.

The higher real rates grind, however, the tighter policy

gets, unless the Fed resumes its easing cycle, which has been on

pause following cuts of 100 basis points between last August and

December. The tariff-fueled uncertainty and volatility of recent

months has helped to extend that pause and, thus, enabled real

rates to rise.

R-STAR, MAN

Real borrowing costs can send vastly different signals from

their nominal equivalents. For example, Japan's official policy

rate and long-dated bond yields are the highest in years, but

the real policy rate is deeply negative and by far the lowest

among the G4 central banks.

In the U.S., the signaling behind today's rate moves is far

from clear. If real yields are rising because investors are

demanding a risk premium to hold dollars and Treasuries, then

it's a cause for concern. If the upward shift reflects strong

growth expectations, then that's much more positive.

But, regardless, one thing is evident. The higher U.S. real

rates grind, the further away they move from 'R-Star', the

amorphous real rate of interest that neither stimulates nor

crimps economic activity when the economy is at full employment.

Two closely watched R-Star models partly constructed by

current New York Fed President John Williams suggest the optimum

real interest rate at the end of December was 0.8% or 1.3%, both

the lowest in years. These figures will be updated for the

January-March quarter at the end of this month. Fed

rate-setters' median projection for the natural real interest

rate is around 1.0%, and this view will be updated next month.

These projections assume inflation at the Fed's 2% target,

which it hasn't been for years. The R-Star concept has come

under heavy criticism since the pandemic. Williams defended it

in July last year, saying it is a fundamental part of all

macroeconomic models and frameworks. "Pretending it doesn't

exist or wishing it away does not change that."

But he also cautioned that R-Star should not be "overly"

relied upon when setting appropriate monetary policy "at a given

point in time" given the uncertainty surrounding it.

So as real rates move further away from this theoretical

sweet spot, what, if anything, is the real-world impact?

Right now, financial conditions are loosening as markets

calm after the market turmoil wrought by the 'Liberation Day'

tariff tantrum last month. But if you exclude that uniquely

volatile episode, conditions have been steadily tightening since

September last year, Goldman Sachs's U.S. financial conditions

index shows.

Further upside for real yields from here may be limited if

inflation ticks higher in the coming months as Trump's tariffs

kick in. But worries over U.S. debt and deficits are beginning

to weigh on the long end of the bond market again.

As investors continue to monitor countless economic

variables to determine where the U.S. economy is heading,

elevated real yields are one they should watch closely.

What could move markets tomorrow?

* Japan GDP (Q1)

* Bank of Japan policymaker Nakamura Toyoaki speaks

* ECB board member Philip Lane speaks

* University of Michigan consumer confidence, inflation

expectations (May)

* Richmond Fed president Thomas Barkin speaks

Opinions expressed are those of the author. They do not

reflect the views of Reuters News, which, under the Trust

Principles, is committed to integrity, independence, and freedom

from bias.

(By Jamie McGeever;)