Fixed income market: the week ahead
Senior Fixed Income Strategist
Summary: This week it's all about the nonfarm payrolls and whether the Federal Reserve will taper purchases under its QE program in November or not. A strong jobs report will hint at a November tapering and more aggressive monetary policies ahead, contributing to a bear flattening of the yield curve. However, a weak nonfarm payrolls report might not necessarily revive the attractiveness of US Treasuries. Indeed, it's becoming apparent that inflation will be a more significant driver than jobs and growth in the future, leading to more aggressive monetary policies anyway. To weigh on long term yields might be the debt ceiling dilemma. Short term T-Bills are offering now a yield more than double than the one of the RRP facility rate. If a resolution is not found, we expect yields to continue to rise in money markets while dropping in longer-term maturities as investors fly to safety. In Europe, ECB speakers and the Minutes for the September ECB policy meeting will be in the spotlight as investors try to come to terms with high inflation.
Will US Treasury yields continue to rise?
That’s the question on everybody’s mind as we are approaching a critical nonfarm payroll on Friday. Last month's jobs miss lead doves to believe that the Fed would postpone tapering further down the line, as their maximum employment target has not been met yet. However, we believe that is just wishful thinking. Indeed, jobs continue to recover while there is no sign yet that inflation is as transitory as the Fed wants us to believe. That makes inflation the primary driver of monetary policies since sustained price pressures will need to be met with unexpected aggressive monetary policies.
There is more potential for jobs to surprise on the upside than to the downside in September, pushing the market to consider an aggressive rate hike path. On one side, jobs openings are at record-high levels. On the other, unemployment benefits expired at the beginning of September, forcing lower-paid labour to return to work. However, to put a strain on the jobs recovery might be the debt ceiling dilemma as budget uncertainties and a potential upcoming government shutdown led to a slower recovery of jobs in the public sector compared to the private sector.
A strong jobs report will definitively weigh on the bond market leading to higher yields in the belly of the curve, but a weak jobs report might not equally lead to lower yields as it’s becoming clear that more aggressive monetary policies will be unavoidable going forward. Doves often point to a slowdown in growth as one of the reasons for the FED to keep dovish. Yet, growth is not contracting: it’s decelerating from extremely high levels brought by the reopening of the economy and base effects. Therefore, it's unlikely that the Fed's tapering agenda will halt in light of slower but sustained growth.
Another question that investors will ask themselves is whether we will see a steepening or a flattening of the yield curve.
Indeed, in the past few days, we have seen the yield curve steepening substantially, with the 2s10s spread widening to 120bps and the 5s30s spread widening to 111bps after plunging below 100bps in the wake of the latest Fed decision. However, the yield curve remains flat compared to the beginning of the year. That is a problem for the Federal Reserve because in case it needs to hike interest rates earlier, it would require the yield curve to be steeper to rule out the risk of curve inversion.
During the last FOMC meeting, the message surrounding rate hikes was bleak. The Eurodollar strip began to price more aggressive monetary policies already starting by this year, considering a 15bps rate hike by December. The potential for early interest rates hikes remain elevated and adds to the risk of a bear flattening with the belly of the curve rising fast and long term yields dropping signaling a Fed’s policy mistake ahead, especially if the market remains preoccupied about slower growth. If the market accepts that slower but sustained growth is no risk, we should see the yield curve steepening instead of bear flattening.
Lastly, debt ceiling talks are becoming more and more important for money markets. On Friday, the yields on T-Bills with maturity at the end of October and the beginning of November doubled in yield. This morning T-Bills with maturity November the 2nd offer 11bps, more than double of the RRP facility. As debt ceiling talks continue without finding a resolution, we can expect more volatility in money markets leading to a bead flattening of the yield curve, which would drag long term maturity lower as they will be seen as a safe haven.
Regarding the supply of US Treasuries, there are no significant auctions this week. Still, next week the Treasury will sell long maturity, which might contribute to bearish sentiment to the longer part of the yield curve.
European government bonds begin to take into account hawkish sentiment among ECB members.
Inflation might soon become a problem for the European Central Bank as well, as it rose to 3.4% YoY in September, with core inflation hitting 1.9%, well above ECB’s expectations. Yet, yields remain stable and continue to be correlated to the US Treasuries, signaling that the market trusts the central bank to stick to its recently communicated symmetric inflation targeting.
However, it may be just the quiet before the storm because soon European sovereign yields will be pushed higher by several fronts:
- Higher yields in the United States;
- The formation of a German governing coalition which includes the Greens and the SPD, hinting at more Bund issuance;
- Sustained inflation and high energy prices lead to more hawkishness within the ECB.
However, the above elements will be in play until the end of the year and potentially until the beginning of 2022.
In the meantime, we could see European yields trading sideways amid a heavy economic calendar. The German economy will be in the spotlight with the release of PMI figures, factory orders, industrial production and trade data. Retail sales figures in the Eurozone will also be out on Wednesday.
To weigh on European sovereign bonds this week are the long list of ECB members speaking and the release of the September ECB Minutes on Thursday, which could give an insight into the central banks' conservative inflation forecasts.
Monday, October the 4th
- Spain: Unemployment Change
- Canada: Building Permits
- United States: Factory Orders (Aug), NY Fed Treasury Purchases 22.5 to 30 years
Tuesday, October the 5th
- Australia: Markit Services PMI Final (Sept), Balance of Trade (Aug), NAB Business confidence, Retail Sales MOM Final, RBA Interest Rate decision
- Japan: Tokyo CPI YoY, 10-year JGB Auction
- United States: Total Vehicle Sales, Balance of Trade, Markit Composite and Services PMI (Sept), ISM Non-Manufacturing PMI, NY Fed Treasury Purchases 7 to 10 years
- France: Industrial Production (Aug), Markit Composite and Services PMI (Sept)
- Spain: Markit Composite and Services PMI (Sept), Consumer Confidence
- Italy: IHS Markit Composite and Services PMI (Sept)
- Germany: Markit Composite and Services PMI (Sept)
- Eurozone: Markit Composite and Services PMI (Sept), Producer Price Index (Aug)
- United Kingdom: Markit/CIPS UK Composite and Services PMI (Sept), New Car Sales
- Canada: Balance of Trade
Wednesday, October the 6th
- New Zealand: Interest Rate Decision
- Germany: Factory orders (Aug), Construction PMI, 5-year Bobl Auction
- Spain: Industrial Production (Aug)
- Eurozone: Construction PMI (Sept), ECB Non-Monetary Policy Meeting, Retail Sales (Aug)
- France: Construction PMI (Sept)
- Italy: Construction PMI (Sept)
- United Kingdom: Construction PMI (Sept)
- United States: ADP Employment Change (Sept)
Thursday, October the 7th
- Japan: Foreign Bond Investment, Coincident Index Preliminary, Leading Economic Index Preliminary
- Netherland: Inflation Rate
- Germany: Industrial Production
- France: Balance of Trade, 10-year Bond Auction, 30-year Bond Auction, 45-year Bond Auction
- Italy: Retail Sales (Aug)
- Spain: To sell bonds (maturities to be confirmed)
- United States: Continuing and Initial Jobless Claims, Consumer Credit Change (Aug), 4-week and 8-week T-Bill Auctions
- Canada: Ivey PMI (Sept)
Friday, October the 8th
- Japan: Household spending (Aug)
- Australia: Building Permits Final (Aug)
- China: Caixin Composite and Services PMI
- Germany: Balance of Trade
- Ireland: Inflation Rate
- Canada: Employment Change (Sept), Unemployment Rate (Sept), Average Hourly Wages (Sept)
- United States: Nonfarm payrolls (Sept), Unemployment Rate (Sept), Average Hourly Earnings (Sept), Participation rate, Wholesales Investors (Aug)