Fixed income market: the week ahead

While the US yield curve was undergoing a massive flattening, breakeven rates were dropping too. That’s quite an understandable move because if the central bank is planning to pull stimulus from the system, inflation is expected to subside as well. Yet, the correction was quite abrupt, with 5-year Breakevens falling to 2.37%, roughly 40bps down from their peak in May. The 5-year 5-year forward plunged to 2.11%, a drop of 30bps from a month ago. We believe that with the breakevens adjusting so suddenly and long-term yields falling too, the bond market is telling us that the Federal Reserve may not be able to keep up with their tightening cycle as growth may lag and inflation should normalize, forcing the central back into a new era of accommodative measures.

Yet, that is a dangerous position to take because there are no signs that inflationary pressures are transitory. While commodities might have peaked, there are still many core price pressures that might have not. Additionally, nothing is telling us that the Federal Reserve will be able to control inflation. Thus, the whole yield curve remains at risk until the transitory nature of consumer prices isn't sure.

Yet, in the immediate future, we can expect the front part of the yield curve to be much more sensitive to inflation expectations and tapering talks. That’s why if Thursday’s PCE index surprises on the upside, we might see short-term yields shifting even higher while long-term yields will stay stable. Ahead of inflation data, we will have the US Treasury issuing 2-, 5- and 7-year Treasuries starting from tomorrow. These maturities are highly vulnerable in light of the recent reversal of monetary policies and short-term inflation expectations. If bidding metrics are week, we could see a further flattening of the yield curve, pushing both the 5s20s and 2s10s spreads to test support at 100bps.

Suppose the yield of 2-year US Treasury bonds rises amid weak demand at tomorrow's auction. In that case, it may be a signal that the market is expecting earlier interest rate hikes than 2022. Last week, 2-year yields rose to 0.27% and stabilized at 0.25% for the first time since April 2020, the high end of the Federal Reserve target fund rate.

The Bank of England will wrongly dismiss increasing inflationary pressures

This week marks the last monetary policy meeting for Andy Haldane, the BoE's chief economist who's leaving to become chief executive of the Royal Society for Arts, Manufactures and Commerce (RSA). So far, he has been the only advocate of an elevated risk of inflation in the country. Last week’s CPI numbers have agreed with his view that inflation in the United Kingdom might be a completely different game from elsewhere. Indeed, Brexit may serve as a multiplier of inflationary force, adding more pressures on specific bottlenecks such as transportation and the labour market. While transportation issues will provoke higher prices on certain goods that now will find it hard to make it to the country, a much tighter labour market might provoke higher wages, which will be a stickier factor of increasing prices.

However, the Monetary Policy Committee will likely leave monetary policies unchanged in light of a delayed reopening of the economy. The minutes of the meeting might also reiterate that inflation will be transitory.

Within this context, Gilt yields will continue to trade rangebound between 0.70% to 0.85%. However, inflationary data and the direction of US Treasury yields are critical to Gilts' performance. If US long-term yields resume to rise and inflationary pressures continue to grow, we can expect Gilt yields to increase fast to 1%.

Economic calendar:

Monday, the 21^st of June

• Australia: Retail Sales
• Germany: Buba Monthly Report
• Eurozone: ECB President Christine Lagarde Speaks
• United States: 3- and 6-Month Bill Auction, Fed’s Williams speech

Tuesday, the 22^nd of June

• New Zealand: Westpac Consumer Survey
• Italy: Industrial Sales
• United States: Redbook, Existing Home Sales, Richmond Fed Manufacturing Index, 2-year Note Auction, Fed’s Chair Powell Testifies before Congress
• Eurozone: Consumer Confidence

Wednesday, the 23^rd of June

• Australia: Commonwealth Bank Services, Manufacturing and Composite PMI
• Japan: BoJ Monetary Policy Meeting Minutes, Leading Economic Index
• Eurozone: Non-Monetary Policy ECB Meeting
• France: Markit Manufacturing, Services and Composite PMI
• Germany: Markit Manufacturing, Services and Composite PMI
• Eurozone: Markit Manufacturing, Services and Composite PMI
• United Kingdom: Markit Manufacturing, Services and Composite PMI
• United States: Markit Manufacturing, Services and Composite PMI, 5-year Note Auction, New Home Sales
• Canada: Retail Sales

Thursday, the 24^th of June

• Japan: Foreign Investment in Japan stocks, Foreign Bond Investment, BoJ’s Governor Kuroda Speech
• Eurozone: European Council Meeting, Economic Bulletin
• Germany: Import Price Index, IFO Business Climate, Current Assessment, Expectations
• France: Business Climate in Manufacturing
• Spain: Gross Domestic Product
• United Kingdom: Bank of England Monetary Policy Meeting and Interest Rate Decision
• United States: Personal Consumption Expenditures (QoQ), Durable Goods Orders, Gross Domestic Product, Initial Jobless Claims, 7-year Note Auction, Bank Stress Test Info

Friday, the 25^th of June

• New Zealand: Trade Balance
• Japan: Tokyo Consumer Price Index
• Eurozone: European Council Meeting, Private Loans, M3 Money Supply
• Germany: Gfk Consumer Confidence Survey
• Italy: Business and Consumer Confidence
• United Kingdom: BOE Quarterly Bulletin
• United States: Core Personal Consumption Expenditures – Price Index, Personal Income, Personal Spending, Michigan Consumer Sentiment Index