Macro: Sandcastle economics
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The good (central banks), the bad (inflation) and the ugly (tapering)
Althea Spinozzi
Head of Fixed Income Strategy
Summary: Yesterday's disastrous 15-year Bund auction showed investors that bond yields can only go higher. Yet, until the German election, the European sovereign space will mimic the US Treasury market. US Treasury yields are trading rangebound since March, and the unprecedented tsunami of liquidity keeps US yields in check. However, we believe that inflationary pressures and tapering fears will put US yields back on track to 2% by summer. Therefore, we may see Bund yields turning positive before the German elections.
Recently falling yields are a diversion from rates’ long-term drivers: inflation and tapering, which will inevitably drive yields higher on both sides of the Atlantic.
In moments like this, it’s crucial to keep the focus on the economic megatrend and catch under-the-radar signals. One of these signals came from yesterday’s disastrous Germany 15-year Bund auction. The German finance agency had to retain part of the €2.5bn target sale amount placing only €1.73bn Bunds because of extremely weak demand. The auction drew a bid-to-cover of 1.06x, the lowest ever recorded for this maturity, even though the bonds offered a positive yield when most German debt still provides negative returns.
The odd part of this story is that the market completely ignored this auction. European sovereign yields, including those of the German bund, closed lower by the end of the day.
What happened yesterday is alarming. Is anybody else besides the European Central Bank buying Bunds? That’s a crucial question for German government bonds and those sovereigns that are dangerously yielding close to 0%, such as France, Spain, and Portugal. Indeed, suppose the demand of European government bonds starts to collapse ahead of the ECB tapering. In that case, we can expect a repricing to be dramatic when the main source of support is lifted.
European sovereigns are tightly correlated to US Treasuries. Therefore, until US Treasury yields trade within a tight range, European yields will keep in check also. We expect the two markets to continue to trade in tandem until German the elections. A new government in Germany will most likely bring a much-needed change in the European bond market, which will see higher yields and tighter spreads across sovereigns.
Yet, until fall, it becomes crucial to understand whether US Treasuries will stay at current levels or not. If they do, we might not see 10-year Bund yields rising above 0% before the elections. On the other hand, if US Treasuries hit 2% before September, there is a chance that we might look at positive yielding Bunds ahead of the German elections.
The signals that we are getting from US Treasury yields are mixed. Yesterday’s bidding metrics for the $61 billion 5-year notes sale was incredibly robust. The auction drew the highest bid-to-cover ratio since September and the highest demand from foreign investors since August.
The reason why we see demand for US Treasuries picking up may be explained by the tsunami of liquidity that cannot find a house within the money market space. Fed's reverse repo volumes are constantly surging, and some of that liquidity might start leaking onto longer-term maturities. Some point to the possibility that this may be a Fed’s strategy to keep the US yield curve in check as the economy heads towards a recovery. However, we doubt such a strategy will demonstrate to be successful if inflation pressures continue to rise.
Why are US Treasuries trading within a tight range?
US treasuries have been trading in a tight range between 1.50% and 1.70% because macro data are increasingly mixed. While it is clear that bottlenecks and the reopening of the economy are increasing inflationary pressures, the lack of workers and a slow down in consumer confidence have the potential to hold back the recovery. This scenario pushes back on expectations that the Federal Reserve will begin tapering purchases earlier than expected, keeping yields trapped within this tight range.
What can be the catalyst for US Treasury yields to break above or below this range?
(1) Inflation. In our opinion, there is more probability for the 10-year US Treasury yields breaking above 1.75% and rise above 2% as inflationary pressures increase than for yields to fall. The preliminary data of the University of Michigan survey show that 65% of respondents see inflation above 3% during the next year. Expectations for the next five year remain high, with 55% of respondents seeing inflation solidly above 3%. The bond market prices over inflation expectations rather than hard inflation numbers. Therefore, tomorrow’s PCE figures and final data from the University of Michigan survey may be key to push the breakeven rates higher.
(2) Tapering. Tapering fears will drive US Treasury yields higher and slow down inflation expectations by pushing yields higher. This is what we saw last week when breakeven rates fell from the multiple-year highs amid the release of the FOMC minutes, which showed members’ willingness to discuss tapering in the following meetings. Tapering is indeed a form for the Federal Reserve to tighten financial conditions by injecting less money into the market. In a recent analysis, Credit Suisse money market guru Zoltan Pozsar recently highlighted that if the Fed announced tapering and lifted Wells Fargo's asset growth ban simultaneously, the system will benefit from extra US Treasuries demand. Although it is a valid point, it much depends on how much inflation will rise. The preliminary data of the University of Michigan survey show that 43% of respondents believe inflation will rise above 5% during the next year. If that were the case, tapering might not successfully contain inflation, and the central bank might also need to hike interest rates.
Tapering talks in Europe are irrelevant unless they take place in the US first. Indeed, the old continent's economy is lagging behind the US recovery. Therefore, seeing the ECB talking about tapering before the Fed would be premature. It doesn't mean that European sovereigns are going to immune to tapering talks. Tapering more than inflation will be a topic that moves bond markets on both sides of the Atlantic because it brings reminiscences of the infamous 2013 "Taper Tantrum”.
(3) Endogenous factor. There can be several endogenous factors that can push yields lower. Although it's difficult for us to envision this scenario, it is important to recognize that if ten-year yields break below 1.5%, we will find support next at 1.2%. One of these endogenous factors could be a massive selloff in the stock market that would provoke a flight to safety and a dovish response by Fed pushing yields lower.
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