Senior Fixed Income Strategist
Summary: This week's US inflation numbers might do little to disrupt markets following the deep rally of last week. Yet, demand at this week's 3-, 10- and 30-year US Treasury auctions will be critical to understanding whether investors' appetite remains intact despite lower yields. In Europe, the Eurozone Sentix and German ZEW are in the spotlight as they will give an insight into the European economic outlook. Yet, as inflationary pressures strengthen and a new government in Germany is in progress to be formed, we expect yields to resume their rise before year-end. Finally, market expectations regarding interest rate hikes in the UK are still very aggressive, implying that there might be some room for Gilt yields to drop.
As bonds rallied amid a strong job report on Friday, we can expect this week’s inflation numbers will do little to disrupt markets.
Indeed, during last week's FOMC meeting, Powell communicated to markets that inflation is subordinated to wages. It implies that the central bank will stick to the Average Inflation Targeting (AIT) framework despite inflation strengthening. Thus, it's safe to assume that the reaction of this week's inflation numbers will be muted unless they exceed expectations by a lot.
In just a couple of days, 10-year US Treasury yields dropped 15bps, the biggest decline since June 2020. The rally was consistent with short-covering and not surprising considering the large open interest volume, which we highlighted on TLT (iShares 20+ Year Treasury Bond ETF) last week. According to a Bloomberg report, there are speculations for 10-year yields to drop to 1,34% by the end of this week. That's a bold call, given that CPI is expected to rise to 5.9%, and we cannot shrug away Friday's robust jobs data.
While at the beginning of last week, the market was expecting slightly more than two rate hikes in 2022, today, it is pricing marginally less than two. Yet, we still anticipate rate hikes expectations to advance by the end of the year as inflation accelerates, and it becomes apparent it will not be transitory. Therefore, we stick to our 2% target for 10-year US Treasury yields by the end of 2021.
The US Treasury is selling 3-year Notes today, 10-year bonds tomorrow and 30-year bonds on Wednesday, after the inflation report. It will be critical to see if the appetite for US Treasuries continues to remain strong despite the recent drop in yields.
Dovish sentiment arising from the FOMC and Bank of England meetings forced investors to reconsider speculations about the ECB hiking interest rate in the next couple of years. The periphery was the biggest beneficiary of the rally, with 10-year BTPS yields spiking to 1.28% at the beginning of the week and then dropping back below 1% by Friday.
What's concerning is how BTP yields rose fast amid fears that the ECB would begin to exit its PEPP program, of which Italy has been the primary beneficiary. It shows how the periphery's fiscal spending continues to depend on the ECB quantitative easing. We doubt the central bank will ever pull support from the third European biggest economy. However, volatility might continue to affect trading activity within this area. This week Italy is selling 3-year and 7-year bonds. Today, it is selling BTP Futura, a retail BTPs issuance, which pays a “fidelity premium" in eight years and at maturity, depending on the country's economic growth. We expect these issuances to price smoothly despite rates having dropped substantially. Yet, it's safe to assume that Italian yields and European peers will need to reprice higher in the long term. Indeed, we expect the German election to bring better European integration and more fiscal spending, translating in higher Bund yields and spread compression across the euro area.
Also, inflationary pressures emerging in the labour market could translate into more persistent core inflation, implying that European yields will need to increase.
Despite the recent setback, which saw 10-year Bund yields dropping below -0.25%, we still believe that there is room for Bund yields to resume their rise to 0% by the end of the year as a traffic light coalition looks likely to form the next German government.
Today the Eurozone Sentix exceeded expectations, hinting at a positive twist for the economy. Tomorrow's German ZEW survey will add more context, although it's safe to assume that the growth rate will decelerate next year.
A rally in Gilts last week was inevitable. The market was pricing much more aggressive interest rate hikes than in the US. However, the drop in yields we witnessed exceeded any expectations. Despite this time around, the BOE was able to push forward interest rate hikes expectations; it's impossible not to envision the central bank going down this road before the economy overheats. Yet, the market might be still overestimating the pace of tightening, pricing four interest rate hikes next year. Therefore, this week growth data, together with a slowdown related to industrial and manufacturing numbers, might further push back hikes expectations, provoking another drop in yields.
On Wednesday, the DMO sells 30-year Gilts through an auction. It will be critical to see if demand remains strong despite yields from 1.55% in October to 1%, a level not seen since August.
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