Senior Fixed Income Strategist
Summary: We expect a dovish FOMC meeting on Wednesday, which will most likely fail to slow down the yield curve's steepening as inflationary pressures become evident by the day. In Europe, Italy faces another government crisis as a Senate vote on Wednesday has become key for Conte's government's survival. Meanwhile, Italy's government bond issuance on Tuesday and Thursday might be the catalyst for a broader selloff in the periphery if demand is weak.
The Federal Reserve meeting this week will be in the spotlight after a week in which the reflation trend has become prominent. Inflation expectations rose to a 2-year high with the 10-year Breakeven hitting 2.18% after the strong TIPS auction on Thursday. At the same time, the Senate panel has approved Janet Yellen as Treasury Secretary, leaving the street certain about an increase of U.S. Treasury bond issuance. Inflationary pressures combined with large government bonds issuance will contribute to a fast bear steepening of the U.S. yield curve inflicting losses to long durations. Suppose Janet Yellen succeeds to issue government bonds with 30+ maturity. In that case, we can expect the steepening of the yield curve to be even faster.
Tapering will most likely be discussed but underplayed by Powell. Although inflationary pressures are getting evident by the day, coronavirus new cases continue to be high, and a more contagious strain from Europe could cause more restrictions to be imposed, limiting inflation’s upside. We believe that tapering will start to be openly discussed only once the vaccine's effects will begin to show in the economy, most likely in the second half of the year. Meanwhile, the U.S. Federal Reserve will continue to expand its balance sheet further- just last week it reached a new record of $7.41 trillion. Powell will acknowledge that economic forecasts improved thanks to the fiscal stimulus. Still, he will highlight that the central bank's policy stance will not change anytime soon regarding interest-rate policy and pace of asset purchases.
The U.S. Treasury will issue 2-, 5- and 7-year notes this week, but these auctions will most likely be uneventful as the Federal Reserve tightly controls the front part of the yield curve.
For bond investors, this effectively translates in continued support for corporate debt, which plays into their favour as the only way to hedge against a rise in interest rates is to seek coupon income. In the short term, a dovish Fed might slow down the increase in yields we have witnessed since the beginning of the year. Yet, we believe that government bonds are explosive as they don't have risk mitigation potential right now as they still offer the lowest yield in history. As explained in last week's analysis, a 50bps move in 10-year Treasuries corresponds to a loss of about 4.7%, while in 30-year Treasuries it can inflict as much as 12% loss.
In the old continent, Germany Ifo survey will probably show that Europe is heading towards a double-dip recession. This data can negatively affect European sovereigns as the market is still digesting the ECB’s passiveness in light of the government crisis in Italy, Netherlands, and Estonia.
Nevertheless, the periphery’s real test will arrive on Wednesday when the Italian Senate will be presented with a motion by the Minister of Justice. Italian newspapers say that there is the possibility that Prime Minister Conte might resign if the motion is not passed causing another government crisis.
It is, therefore, crucial to monitor demand for the country’s government bonds. Italy is to sell notes on Tuesday and Thursday with maturity up to 10-year. Last week, demand for Spanish bonds was weak with the bid-to-cover ratio for 7-year notes falling more than 70% compared to previous auctions. Ten-year BTPS closed the week at 0.74%, 13 basis points wider on the week reaching the highest yield since November. If sentiment continues to deteriorate, 10-year BTPs might find new resistance at 0.8%.
We believe that any short-term weakness in BTPs represents a buying opportunity. Indeed, on one side, we believe that early elections are the least likely outcome. On the other, the ECB will need to continue to inject more money in the system until a recovery path is clear and more fiscal stimulus is added, which won’t be the case this year as German elections are underway. As the ECB prepares to use its full firepower, European sovereigns that trade richer against their peers, such as Italy, will continue to tighten.
Economic Calendar
Monday, the 25th of January
Tuesday, the 26th of January
Wednesday, the 27th of January
Thursday, the 28th of January
Friday, the 29th of January
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