Head of Fixed Income Strategy
Summary: This week it's all about inflation. Although breakeven rates fell last week, real yields remained stable. It implies that the market continues to buy into the Fed's Average Inflation Targeting (AIT) message, even though the FOMC minutes showed that members are open to talk about tapering in future meetings. Therefore, today's consumer confidence data may revive inflation expectations pushing breakeven rates higher. More importantly, Personal Consumption Expenditures are due on Friday. If they surprise significantly, we might see ten-year US Treasury yields resuming their rise towards their resistance at 1.75%. If the surprise is marginal, US Treasury yields will likely not move much until the following jobs report on the 4th of June. In Europe, the ECB should be alarmed to see Italian government bond yields solidly trading above Greek peers. It shows that the ECB's various QE programs may create distortions within the European sovereign space and that the periphery, including France, is poised to a brutal correction as Bund yields continue to rise.
Prepare for a volatile week ahead amid inflation focus.
This week, the bond market is going to focus again on inflation numbers. The Personal Consumption Expenditure Index (PCE), coming out on Friday, will be critical. The PCE is the Federal Reserve’s preferred inflation measure, and if it surprises expectations, it could trigger another selloff in the bond market as inflation risk increases the risk of tapering, also. Economists expect the index to climb to 0.6% MoM and 3.5% YoY. A great surprise in this data could trigger 10-year US Treasury yields higher, pushing them closer to their resistance at 1.75%. On the 12th of May, the Consumer Price Index (CPI) came out hot at 4.2% YoY, with April’s figure, excluding food and energy, at 0.9% versus 0.3% expected. While the yearly figures are transitory because of last year's depressed numbers, nothing suggests monthly data are transitory, too. That’s why if the PCE exceeds estimates greatly, the FED may start contemplating withdrawing monetary support and taper purchases under their quantitative easing program sooner than forecasted. Tapering fear remains critical for bond investors, especially after the last FOMC minutes.
While PCE numbers focus on hard inflation data, the consumer confidence data released today will give a glimpse over inflation expectations. Since peaking in the middle of the month, the Breakeven rates fell following the latest FOMC minutes. The report showed that several Fed’s officials believed it appropriate in the upcoming meetings to discuss adjustments in the central bank's asset purchases. Yet, although the 5-year Breakeven rate fell 20 basis points from its highs, it remains at the highest level since the global financial crisis of 2008. Also, the 10-year Breakeven Rate and the 10-year Zero-Coupon swap are still the highest in more than seven years despite the recent correction.
Yet, the FOMC meeting occurred before April’s dreadful jobs miss. It can explain why while breakeven rates corrected, real rates barely moved. It suggests that the market still believes that the Fed will stick its guns with the Average Inflation Targeting (AIT) framework and not tighten conditions until full employment, despite inflation overshooting its target. That’s why, if the PCE numbers don’t surprise greatly, the bond market may not move until the May employment report coming out on the 4th of June.
European sovereigns yields retreat, but there is still trouble ahead as Italian government bonds yields remain higher than Greece's.
European sovereign yields are falling following Friday's Ms Lagarde comments. The ECB president said that the central bank remains committed to maintaining favourable financial conditions throughout the pandemic period, sending a dovish message that weighs on European sovereign yields. On top of it, purchases under the PEPP program have increased to roughly EUR 80 billion net purchases per month, the highest since July last year.
Economists point to the fact that the ECB should relax and look at the rise in yields favourably as the macroeconomic backdrop strengthens with the reopening of the economy. Indeed, the rise in German Bund cannot be attributed any longer to an increase in US Treasuries yields because the latter stabilized in the past few months while Bund yields continue to rise. While a lower correlation between US Treasury yields and Bund yields is welcome, another troubling factor cannot be left unnoticed. This month, Italian government bond yields have broken above those of Greece. The move is worrisome because it shows that either the ECB’s various QE programs create distortions within the European sovereign space or that the periphery, including France, is poised to a brutal correction. As explained in last week’s analysis, there is no political concern right now that should wait negatively on the BTPS. Secondly, fears of lack of BTPS’ future issuance demand are unfounded because the ECB will be able to support this issuance, and the higher yield will attract both real money with long term investment horizon and demand from investors looking to park liquidity in the short-term to avoid negative-yielding deposit rates.
Greek government bonds present much higher credit, rotation and liquidity risk compared to their Italian peers. The same can be said about Portuguese sovereigns. French and Spanish government bonds don't present the same liquidity issues; however, they are at significant risk of rotation as they pay less than EUR-hedged US Treasuries.
It reinforces our belief that Italian BTPS are now trading rich and remain much less vulnerable to a repricing as German Bund yields continue to rise. The spread between 10-year Italian BTPS and comparable Bund yields should stabilize around 100bps until fall. Following the German elections, we expect better European integration and higher fiscal spending, which will further compress this spread.
Economic calendar:
Monday, the 24th of May
Tuesday, the 25th of May
Wednesday, the 26th of May
Thursday, the 27th of May
Friday, the 28th of May
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