Rates Spark: Unprotected

The key take-away from yesterday's commentary is that Chair Powell is prepared to let inflation take off, and is unlikely to take action in the face of that, unless it gets out of control. The problem is we won’t know whether it is in or out of control until it allowed a bit of space. That’s quite an uncomfortable set of circumstances from the perspective of the fixed income investor, and especially for longer tenors, the value of which can get quickly eaten away by inflation.

A move higher in long rates has been the impact reaction, and it would not surprise us if this was followed through with more rises in the weeks ahead. Also, we have a week of long duration auctions to get through next week, which will prove a real test of where sentiment is.

The issue here is that the back end is being left unprotected by the Federal Reserve. We believe this is neither a good thing nor a bad thing. It is a statement of fact.

Chair Powell is intent on getting the maximum oomph from the Fed's policy easing, and indeed monetary conditions do remain exceptionally easy. The only lever that is tightening, is long end rates, but so far this is tolerable, as it is primarilly a function of reflation expectations.

Importantly, the rise in yields is not a ratchet up on supply indigestion. That might come. But it is not here and now. This is important, as something like that could cause the Fed to show more concern. In contrast, a decent macro foundation is music to the Fed's ears, as that is the whole purpose of an easy monetary policy in the first place.

Meanwhile, the front end remains absolutely anchored, meaning more curve steepening. And the 5yr part of the curve has started to cheapen again to the curve, pointing to an upside bias for longer term rates on the back of all of this.

US Treasury auctions next week will also move into the spotlight

The stage has now been largely set for the upcoming central bank meetings. There are still a couple of events to watch. Of course there is today’s US jobs report (see below) and the progress of the stimulus bill in the Senate to keep an eye on. Given a pending decision on the SLR (Supplementary Leverage Ratio), i.e. the exemption of USTs from bank capital requirements that runs out at the end of the month, the US Treasury auctions next week will also move into the spotlight, especially the long end auctions where Powell has provided little backing. Recall that it was a dismal Treasury auction that added to last week’s push in 10Y yields toward 1.6%.

The ECB meeting next week will be the first act, though. The ECB has entered its quiet period and judging by the outperformance of EUR rates yesterday, it appears the market is already beyond the point where there can be any further disappointment. The latest comments by the ECB’s Knot give little hope for concrete action next week. The view that higher yields reflect the improving outlook chime with earlier comments by the equally hawkish minded Jens Weidmann.

It is crowded ahead of the ECB, which could curb chances for the EUR bond markets finding relief.

Ahead of the meeting the focus turns to primary markets. In the periphery Italy and Ireland are active. More important, shorter dated 5Y tap out Germany and 7Y tap from the Netherlands leave ample room for the EU to raise further funds for the SURE programme where in total still €20bn are planned for the month. A single tranche deal might leave enough room for France to squeeze in – markets are anticipating a new 20Y green bond soon. The upshot remains, it is crowded ahead of the ECB, which could curb chances for the EUR bond markets finding relief.