Head of Fixed Income Strategy
Summary: The bond market is providing contradictory signals. While nominal rates are biting the "lower for longer" Federal Reserve's message, breakeven rates have fallen amid tapering fears arising from the latest FOMC minutes. This week's ISM Services PMI numbers and nonfarm payrolls provide an opportunity for breakeven rates to resume their rise, reviving the reflation trade. In Europe, the consumer price index will be in focus, and we don't expect it to lead to discussions about tapering among ECB policymakers. Last week's weak 15-year Bund auction shows that European countries need the central bank's support to carry their financing operations. This week's 30- and 50-years OAT auction will be vital to understanding whether appetite for duration continues to deteriorate, causing yields to rise even further ahead of the German election.
The bond market buys “lower for longer” Fed’s message, but breakevens don’t
The market expects the Federal Reserve to hold to their Average Inflation Targeting (AIT) framework despite a sustained rise in inflation data.
It was clear on Friday when yields failed to move, although the core Personal Consumption Expenditures (PCE) data showed an increase of 3.1% YoY, the highest pick up in nearly thirty years. Shortly after, the University of Michigan published their latest survey showing that consumer sentiment and current economic conditions deteriorated since the previous month. It led to a fast drop of yields across the curve, which pushed 10-year US Treasuries back below 1.6%. Investors conclude that if the macroeconomic backdrop doesn’t strengthen, the Federal Reserve will not taper even if inflation gets really hot.
There is a problem with that rationale.
While the market debates concerning the temporary nature of inflation, nobody knows how much inflation will rise and how long for is going to stay high. The recent University of Michigan survey shows that more than half of the respondents expect inflation to sustain above 3% in the next five years. The same study showed that the median for the expected change in prices during the next year is 4.6%. If that were the case, it is unlikely that Fed’s members won’t start looking at inflation with concern, and the dot-plot will need to advance.
Any discussion concerning tapering or moving in the FOMC dot-plot is pivotal for yields to resume their rise. The latest FOMC minutes provoked a fast correction of breakevens as it suggested that members were open to starting discussing tapering. The move contradicts the “lower for longer” Fed’s mantra. Both breakevens and the inflation swap market right now are indicating that tapering talks may be a probable outcome during the next monetary policy meetings.
Tapering talks is not the only factor that may drive yields higher. Indeed, bonds price on inflation expectations rather than on hard inflation data. Thus, if breakeven rates resume their rise, we can expect bond yields to point higher too. That’s why this week’s jobs numbers are in focus. Last month’s nonfarm payrolls miss put the reflation trade on pause. Suppose the employment report exceeds expectations on Friday. In that case, there is the possibility that breakeven rates start to rise, reviving the reflation trade.
The ISM Services PMI out on Thursday is also forecasted to rise in May, putting more pressures on the reflation trade ahead of the NFP numbers.
Europe Focus: CPI numbers and France 30- and 50-year OAT auction
In Europe, the focus will be on inflation numbers, with the Eurozone consumer price index forecasted to rise 1.9% YoY, the highest in three years and close to the ECB target. Even a slight surprise in this number could push yields higher as tapering fears increase. However, we believe tapering fears in the euro area will be premature. Indeed, the European Central bank will be reluctant even to start thinking about pulling support amid today's disappointment in the monetary aggregate M3, which decreased to 9.2% in April from 10.1% in March. The data shows that credit access might be tightening, although the economy is just starting to emerge from lockdowns.
Not only, but last week’s disastrous Bund auction highlighted the necessity of the ECB to continue with its QE programs, including the PEPP, to support countries’ ongoing financing operations. Last week, the German finance agency had to stop the sale of 15-year Bunds amid weak demand, allocating only €1.7 billion out of the €2.5 billion targets. Demand for Italian 5- and 10-year BTPS on Friday was the weakest since the beginning of the year. That's why it will be essential to monitor government bond auction in Europe this week, particularly in France, as the country is looking to sell bonds of various maturities, among which 50-year OAT (FR0014001NN8). The bonds fell roughly 20% since issuances (January 2021). They are currently pricing 75 cents on the dollar, while yields rose from around 0.55% to 1.15%. Bidding metrics at this auction will be vital to understanding whether market appetite for duration continues to fall. If that were the case, it would reinforce our belief that yields in the euro area need to dramatically rise, with the German elections being the biggest catalyst for such change.
The ECB will be reluctant to pull support within this context and will most likely keep current monetary policies unchanged.
Economic Calendar
Monday, the 31st of May
Tuesday, the 1st of June
Wednesday, the 2nd of June
Thursday, the 3rd of June
Friday, the 4th of June
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