Head of Fixed Income Strategy
Summary: Prepare for an intense week in which the issuance of 10- and 30-year bonds will test appetite for US Treasuries just after the Consumer Price Index data release. As US Treasury yields continue to rise, pushing up high-grade corporate bonds' yields, the rotation from stocks to bonds becomes more and more compelling. Be wary of the 1.65% level in 10-year yields, which has the potential to trigger another squeeze within the Mortgage-Backed Security (MBS) market, setting yields on a fast track to 2%. In Europe, the focus will be on the European Central Bank's bond purchases data released today and the central bank's monetary policy meeting on Thursday. Italy is to test the market's appetite for BTPs for the first time since the weak 5-year bond issuance on February the 25th, driving market sentiment in the periphery ahead of the ECB's interest rate decision.
This week the bond market has plenty of reasons to continue the selloff it started last week. Last Thursday, Jerome Powell predicted an increase in consumer prices this summer. Still, he remained dovish, stressing that we are far away from maximum employment and long-term inflation. The Secretary of the US Treasury, Janet Yellen, also downplayed the rise in yields on Friday saying that they signal a recovery. Mrs Yellen even added that the $1.9 trillion fiscal stimulus package is not excessive. These statements lead the market to take direct control of monetary policies pushing yields higher. For the first time since February last year, the yield on 10-year US Treasury Bonds closed above 1.5%. We believe that this week there is scope for yields to continue their rise, and if they get close to 1.65% level, we might witness another squeeze within the Mortgage-Backed Security (MBS) market, which could send yields on a fast track to 2%.
Catalysts for such a selloff could be Wednesday’s inflation numbers preceding the 10- and 30-year US Treasury bond auctions. Although the Treasury’s auctions are often uneventful, the ones coming up this week could prove interesting. A couple of weeks back, the 7-year note auction tailed by 4.2 basis points, the most in the auction's history. Even more worrying, foreign demand dropped dramatically, with indirect bidders plunging to the lowest since 2014 from 64.10% to just 38.06%. Foreign demand for US Treasuries is crucial to support the considerably large bond issuance in light of higher government spending. If foreign demand lingers, the selloff in US Treasuries could intensify considerably, leaking to other assets. Today’s release of the Treasury auction allotment of the 20-year note auction of February 17th will be key to preparing for this week's auctions as it will give a snapshot of the demand for long-term Treasuries. Unfortunately, the auction allotment for the recent 7-year note auction will not be released until March the 22nd.
Developments in the bond market are key for risky assets' performance, too, particularly for the stock market. As Treasury yields rise, not only a higher discount rate will be applied to future expected corporate's earnings, but the relative advantage to hold overvalued stocks trading over 25x P/E ratio versus holding bonds is going to narrow. Indeed, while the option-adjusted spread (OAS) of US corporate bonds remains the tightest in twenty years, their yield to worst (YTW) started to rise together with US Treasury yields. While at the beginning of the year, high-grade corporate bonds were providing an average YTW of 1.75%, now they pay around 2.2% YTW. If the yield on investment-grade (IG) corporate bonds continue to rise, the rotation from stocks to bond will become more and more compelling as investors will be able to secure a good return, by investing in safer assets while avoiding any turmoil in the stock market. We believe that we will see such rotation as the US 10-year Treasury yield nears 2% and the average yield of US IG corporate bonds rises to 2.75%, the minimum YTW this asset class has been providing in the past seven years.
Meanwhile, junk bonds will continue to be supported for the simple reason that right now, amid economic recovery and rising inflation expectations, high yield corporate bonds are the only assets to offer a buffer against rising yields. Only when the high-grade corporate space will become a real alternative to stocks, as highlighted above, we will see the market reassessing risk provoking a widening of high yield corporate spreads tightening financial conditions considerably.
We remain of the opinion that ultimately the Federal Reserve will have no other choice other than engaging in Yield Curve Control (YCC) when 10-year yields will get close to the pivotal 2%. Powell's speech last week was clear in saying that Federal Reserve will intervene to stop disorderly markets and the tightening of financial conditions making YCC very likely despite a booming economy scenario. This behaviour could lead to a severe monetary policy mistake.
In Europe, the market will focus on the ECB’s bond purchases data that are going to be released today to understand whether the central bank is acting on its promises to keep European sovereign bond yields in check. If the report disappoints, we might be facing another week of a selloff in European government bonds that will most likely stall with the ECB Interest Rate Decision and Press Conference on Thursday. We believe that a temporary increase of the PEPP’s pace is likely, which could focus on bonds of those more volatile countries, given the lack of collateral that the Euro area is suffering from.
Before the ECB monetary policy meeting on Thursday, it will be important to monitor Italy’s 3- and 7-year notes auctions as the recent 5-year BTP auction registered the lowest bid-to-cover ratio since June amid the selloff in European sovereigns. Last week, Italy’s green bond issuance attracted more than 80 billion euros in bids; however, it's important not to commit the mistake to compare such issuance with traditional BTP issuances. Indeed, last week's green bond was a debut for Italy in this space, coming at a time when the supply of these instruments continue to be limited while the green bond investors base continues to grow. On Thursday, Italy will test appetite for traditional BTPs for the first time since the weak 5-year Bond auction of February the 25th, driving sentiment for the whole periphery before the ECB interest rate decision.
Economic Calendar
Monday, the 8th of March
Tuesday, the 9th of March
Wednesday, the 10th of March
Thursday, the 11th of March
Friday, the 12th of March
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