Quarterly Outlook
Equity outlook: The high cost of global fragmentation for US portfolios
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Today’s bond rally it’s just a chapter, not the whole story
Althea Spinozzi
Head of Fixed Income Strategy
Summary: Japanese buyers have come to rescue falling US Treasuries. However, the more significant test will come today as the Treasury will sell 30-year bonds following the US CPI readings. With inflation expected to close the year above 4% and GDP expected around 5.9%, it's unlikely that long-term yields will drop despite a slowdown in growth. Therefore, we might see the yield curve to bear-steepen amid tapering expectations first to then bear-flatten as the market considers earlier interest rate hikes. In Europe, strong demand for 30-year Bund and 30-year BTPS is driving yields lower. Yet, we expect Bund yields to rise to break above 0% by year-end amid strong inflation expectations, a new German government and higher yields in the US.
US Treasuries: Japanese buyers are back.
Since the beginning of October, Japanese investors have resumed buying US Treasuries. That provided ample support during yesterday's 10-year bond auction, with the bid-to-cover ratio at 2.58x and indirect bidders taking down 71.1% of the issuance in line with last month.
It was a surprising turnaround following a weak 3-year note auction where indirect bidders fell to 44.2%, the lowest since November. The solid 10-year auction stopped through the When Issued at 1.59% by 0.6bps caused yields to drop further in the secondary market.
The big question is whether we will see the same strong demand at today’s 30-year US Treasury auction, following the US CPI readings. The yearly CPI figures are expected to remain in line with the previous reading at 5.3% and the monthly at 0.3%. A surprise on the upside could trigger higher inflation expectations leading yields to rise across the curve. At that point, it will be critical to see whether indirect bidders are coming to the rescue during today's 30-year auction, or they'll be waiting on the sidelines.
With inflation expected to close the year above 4% and GDP expected around 5.9%, it's unlikely that long term yields will drop despite a slowdown in growth. We could see the US yield curve to bear steepen as the market prepares for the Fed to taper. However, a bear flattening of the yield curve where short-term yields rise faster than long-term yields is more probable, making it possible for 10-year yields to break above their year’s high at 1.77% and continue to rise towards 2%.
German Bunds: not ready for 0% yet.
Yesterday, we saw 10-year Bund yields rising to -0.08% for the first time since May pushing towards zero for the second time since 2019.
However, today we are witnessing a strong reversal driven by German CPI data in line with expectations and a solid 30-year Bund auction. The auction received a bid-to-cover of 2x, the highest since October 2020. Strong demand can be explained by the fact that 30-year Bund yields rose to the highest since June yesterday, enabling the auction to price with an average yield of 0.35%, the highest since June 2019.
Yet, we still expect Bund yields to rise towards 0% by the end of the year driven by inflation expectations, a new German government and higher yields in the US.
To strengthen demand for European sovereign bonds was also an exceptionally strong 30-year BTPS auction. Italy sold 30-year bonds at a bid-to-cover ratio of 1.53x, the highest since November 2019. The country also sold 3-year and 7-year notes, which also attracted strong demand. It pushed 10-year BTPS yields to break below their ascending trend line, which led them to test resistance at 0.92%. We still expect Italian 10-year yields to rise during the last quarter of the year and stabilize above 1% by year-end.
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