Head of Fixed Income Strategy
Summary: This morning US Treasuries are boosted by falling stock futures and the expectations that Asian buyers will buy bonds amid the end of their fiscal year on Wednesday. Still, last week's Treasury auctions didn't see an extensive increase in buyers, leaving bidding metrics well below one-year averages and sentiment in bonds bearish. Thus, any news concerning higher inflation expectations or disappointment in bonds' demand might be a catalyst for a deeper selloff. Even if Asian buyers underpin Treasuries this week, we believe that yields will remain volatile in the mid-term. If a strong recovery ensues, spurring higher inflation, there is the chance that 10-year yields will rise fast towards 2% by summer. In Europe, Italy, France and Germany will issue long-term bonds. The issuance of 10-year OATs will be critical to understanding whether the ECB's policies aimed at controlling yields in the euro area are successful. In England, the focus is on a weak corporate sector that may force the BOE to take a step back from its hawkish stance.
(1) United States: US Treasuries are vulnerable amid rising inflation expectations spurred by Biden’s infrastructure and April relief bills.
Even though the US Treasury is taking a break from long-term bond issuances, this week could be pretty eventful. Amid a light economic calendar, the focus will be on President’s Biden speech on Wednesday and job figures coming out on Good Friday. From last week’s auctions, we learned that demand for US Treasuries remains weak despite yields rose to levels last seen at the beginning of 2020. The conflicting monetary policies that the Federal Reserve enacts is pinning down the front part of the yield curve while leaving long-term yields exposed to selloffs. This strategy poses a critical threat as bond vigilantes carefully monitor inflation expectations, which continue to rise amid a fast vaccination campaign and a more robust economic outlook.
A miss in Personal Consumption Expenditure (PCE) on Friday didn’t deter inflation expectations. The 10-year Breakeven rate hit a new high at 2.35%, the highest since April 2013. At the same time, the 10-year zero-coupon inflation swap rose above 2.5%, the highest since September 2014. The market tells us that if inflation doesn’t show in the data gradually, it might come as a surprise. Furthermore, data show that a more significant number of investors are preparing for higher inflation. A recent survey by the Federal Reserve of Minneapolis shows that around 30% of traders expect inflation above 3% in the next five years. Moreover, the Federal Reserve of Atlanta shows that businesses expectations rose to 2.4%, the highest in ten years.
Biden’s speech on Wednesday and jobs’ data on Friday can further exacerbate bearish sentiment in Treasuries.
It’s important to note that Treasuries might be supported this week by a more significant number of buyers as the first quarter of the year comes to an end. Japanese investors close the fiscal year on Wednesday, making them likely Treasury buyers, providing much-needed support for Treasuries. Also, the US safe-haven can gain following the selloff in the stock market spurred by the unwinding of large block trades from Friday.
The stock market will be closed on Good Friday as nonfarm payrolls will be released. Still, although liquidity will be limited, the bond market will be open until midday. Even if bond volatility is contained this week, we believe that the closer we get to recovery, the more likely it is for 10-year yields to rise towards the pivotal level of 2%. Such a level will put the stock market, especially overpriced assets, in a challenging position.
(2) European sovereign bond issuances might find a hostile market
This week, Europe will issue a considerable amount of long-term government bonds. Italy will start with selling 10-year Bonds tomorrow. Germany will follow with 15-year Bonds on Wednesday, and France will sell 10-year bonds on Thursday.
It will be crucial to see if bidding metrics are deteriorating for French OATs, which have been tumbling since the beginning of the year but continue to offer negative yields. News regarding slow Covid-19 vaccinations and a surge of infections adds to the threat of a weak auction on Wednesday as the country’s hospitals are treating an unprecedented number of Covid-19 patients. French 10-year OAT yields rose more than 20 basis points since the beginning of the year, and they now offer -0.1%. If they turn positive, they might put further pressure on the ECB, which is already fighting to keep yields from rising.
That said, we believe that demand for Italian sovereigns will show resilience for the simple fact that BTPs continue to offer an attractive yield compared to that of their peers. Additionally, the Draghi effect continues to provide critical support to the country's government bonds. Indeed, since the beginning of the year, yields rose much less since compared to that of other European countries. Ten years BTPs rose only by six basis points YTD compared to more than 20 basis points for France, Germany, Spain and Greece.
The European Central Bank’s attempt to keep yields in check by increasing purchases under the Pandemic Emergency Purchase Programme (PEPP) is not proving fruitful. On Friday, as the Treasuries sold off in the United States, European bonds tumbled as well. We believe that the ECB is fighting an uphill battle as it is evident that yields in the United States will continue to rise in the mid-term, and it will be impossible for the central bank to break the positive correlation between the US Treasuries and their European peers. The best the ECB can do is keep the correlation between the two markets as close as possible to zero. Still, it will run into the risk to provoke an exodus from the periphery, which already offers little if no pick up at all over US Treasuries once hedged against the euro.(3) Turmoil corporate space could force the BOE to keep Gilt yields in check
Last week, Keith Skeoch, the Financial Reporting Council's interim chair, warned that turmoil is coming in the UK corporate sector. As the country is heading towards a strong recovery this summer, the Bank of England will need to withdraw the Covid-19 business support scheme, leaving many businesses vulnerable to default. If that were the case, the Bank of England would need to be less hawkish. In case it decides to withdraw support for corporates, it may need to control rising yields, which will inevitably pose a threat to weaker companies. Although Gilt yields seemed to have stabilized in March, they have quadrupled since the beginning of the year, going from 0.19% to 0.75%. As the economy recovers and the BOE continues with its hawkish stance, we can expect yields to rise to test the 1% support line quickly. At this point, the tightening of the economy's financial conditions will be visible, and the central bank may be forced to intervene to slow down yields.
Economic Calendar:
Monday, March the 29th
Tuesday, March the 30th
Wednesday, March the 31st
Thursday, April the 1st
Friday, April the 2nd – Good Friday
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Head of Fixed Income Strategy