Senior Fixed Income Strategist
Summary: The European Central Bank monetary policy meeting and CPI figures in the United States are key drivers for the market this week. We expect the ECB to maintain the monetary policy unchanged as bond purchases will naturally slow down with the primary market during the summer holidays. Yet, the performance of European sovereigns will continue to be tight to that of US Treasuries. Thus, the CPI figures are critical as a spike in monthly core CPI may indicate that inflation is not transitory and that tapering talks may be necessary. As a result, US Treasury yields have the potential to continue to trade rangebound or even fall in the short term due to a dovish Fed. However, in the long term, they will inevitably rise to try the pivotal 2% resistance.
Don't expect tapering talks at this week's ECB monetary policy meeting.
A substantial part of the market has been fretting about June’s ECB meeting as the central bank is due to revise purchases under the PEPP program. Tapering fears have prevailed in the month of May as the rise in European nominal yield accelerated compared to the 10-year EUR swap rate. Yet, in the past couple of weeks, yields corrected, showing that the market might have been ahead of itself.
We believe that it is premature to talk about tapering in the euro area as the economy is just opening up after a long period of lockdown. Not only, but the ECB will be reluctant to withdraw support at a time when bond purchases will naturally slow down as the primary market goes on summer holiday. Demand for European sovereigns, Bunds, in particular, has been weak recently, making unviable any kind of tapering.
Additionally, we don’t expect the ECB to lead the Federal Reserve in terms of tightening monetary policies, delaying tapering fears at least until the Jackson Hole meeting in August.
Ahead of the ECB meeting on Thursday, it will be key to watch out for bidding metrics during the 7-year Bund auction tomorrow and the 30-year Bund sales on Wednesday. Lately, Bund auctions have not drawn enough interest. The German finance agency placed only roughly €1.7 billion out of the target €2.5 billion at the latest 15-year Bund auction. It's crucial to see whether investors will add duration now that 30-year Bunds are offering a yield of 0.35%, one of the highest yields they provide in two years. If demand is weak, it implies that the long part of the German yield curve is not fairly priced, which may provoke a further steepening ahead of the ECB meeting.
Italy is also issuing 3- and 7-year BTPS ahead of the monetary policy meeting. Therefore, we expect demand to be solid as BTPS continue offering the highest yield in the euro area.
It’s important not to forget that European sovereigns continue to be tightly correlated with US Treasuries. Therefore, if we see yields rising in the US, the dovish message of the ECB might be useless to keep yields in check.
CPI figures might add to tapering fears.
Friday’s jobs miss highlights that widespread shortages might soon weigh on the recovery. Since the global financial crisis, central banks' default answer to such data would have been more monetary stimulus. That's the only reason why US Treasury yields fell on Friday afternoon, with 10-year yields closing at 1.55%, the lowest since April. Yet, this time around, things might be different. Unit labor costs have risen 1.7%, although forecasts were showing a fall of -0.4%. It raises questions on whether the rise in inflation we are witnessing is transitory or not.
Yesterday’s Janet Yellen comments regarding the beneficial nature of higher interest rates for both the Federal Reserve and society raises even more doubts about the Fed's dovish message. Yellen, the “deficit dove”, might be preparing the ground for tapering talks ahead, as if inflation continues to strengthen.
This week’s core CPI is expected to show a rise of 3.4% YoY, the highest since 1993. However, the most critical data will be the monthly figure which is expected to come at 0.40%, well below the prior reading of 0.9%. If we see this number exceeding expectations, the bond market might throw a tantrum. Indeed, while yearly CPI readings are transitory, the monthly ones might not be, making early tapering talks more likely.
Ahead of the CPI figures, bond investors will need to monitor tomorrow 3-year and Wednesday's 10-year bond auction, which can give clues about market positioning ahead of the CPI readings and next week's Federal Reserve monetary policy meeting. On Thursday, the US Treasury is set to sell 30-year bonds following the CPI numbers.
We remain of the opinion that at next week's monetary policy meeting, the Fed will stick to its Average Inflation Targeting framework. However, it will need to revisit its stance during summer as inflationary pressure peaks. We expect to receive tapering signals as soon as Jackson Hole, while tapering may happen as soon as September.
Within this environment, 10-year yields have the potential to trade rangebound or even fall in the short term if the Fed continues with its dovish signal. Yet, the long term trend is for them to move higher and try the pivotal 2% level during summer.
This week's monetary policy decision from the Bank of Canada on Wednesday and Russia on Friday can also weigh on US Treasury yields. If their policies exceed expectations regarding tightening, tapering fears will rise in the US, too.
Economic Calendar
Monday, the 7th of June
Tuesday, the 8th of June
Wednesday, the 9th of June
Thursday, the 10th of June
Friday, the 11th of June
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