Rates Spark: Could Have Been Worse

(MENAFN- ING) US breakevens are up, but just in short tenors, and actually not by that much

We've seen a remarkable calming in circumstances over the first full day of market trading in the wake of the US/Israel attacks on Iran. The impact effect was dramatic, as volatility spiked, risk assets sold off, spreads widened, bond yields fell and the US dollar rallied. As Monday rolled on, that initial spike unwound, practically completely in many cases. We don't typically do running commentaries on the markets, but here it's important, as many of Monday's market moves portrayed a preliminary market impression that "we've seen this movie before." For example, the VIX volatility index was pared right back down to where it closed on Friday, CDS-based credit spread indices narrowed right back in to close to Friday's levels (albeit still a tad above), and the 10yr Treasury yield snapped right back above 4% (having initially dipped below 3.95% in the early morning).

But there are other areas where impact moves have been broadly sustained. For example, the price of oil snapped higher, and has remained elevated (albeit off the highs), and the dollar has managed to hold on to a reasonable bid, and inflation breakevens spiked higher, and that too has been broadly sustained. Then again, the moves have not been that dramatic. The oil price, for example, is up, but from US$67/bbl on Friday to US$71.5/bbl as we head to the close on Monday. Hardly dramatic. The 2yr US breakeven inflation rate ended Friday at 2.8% and is now at 2.9%. Two things there. First, it was already relatively high, and second, the Iranian attacks have added to them, but only by 10bp. Moreover, the 10yr US breakeven rate is up just 3bp, to a relatively benign 2.3% (a level that Chair Powell impliedly is comfortable with).

Frankly, we've been surprised that the safety flight into bonds was as short as it was. We can, of course, reverse engineer a rationale as to why the 10yr Treasury yield popped back above 4% (inflation fears). Should circumstances become more sinister from a wider lens across the region, there would no doubt be a renewed safety flight. But the impact reaction following on from the initial impact reaction has been remarkable.

Inflation risks dominate the safe-haven narrative in the eurozone

Eurozone rate markets see inflation risks as the key fallout from the Middle East escalation, and as long as energy prices stay elevated, that won't change. Rates rose most on the front-end of the curve, but also further out the curve, the move was upwards. The rise in euro inflation swaps was consistent with our model based on oil and gas prices, justifying an increase of almost 15bp in 2Y inflation swaps. Gas prices in particular should be watched closely, with the TTF up more than 30%. Having said that, energy prices have already eased from their peak on Monday, suggesting the initial panic reaction is behind us for now.

The question is whether the 2Y euro swap rate has much room to rise from here, as that would imply an ECB rate hike next. On Friday, markets still saw a 50% probability of a rate cut in 2026, but this is now zero. The ECB's Wunsch has already voiced not to rush any policy actions in reaction to the moves in energy prices. This seems sensible, given that only a few weeks ago we were debating a possible cut on the back of a stronger euro. Now the discussion is about euro weakness. The world can change rapidly these days. On the other hand, markets have not forgotten about the last bout of“transitory” inflation.

We think the next move of the 10Y euro swap rate is higher, but the timing is difficult. Before the weekend, we already had multiple risk events weighing down the curve, including AI jitters and renewed tariff uncertainty. Bund yields were braced for more bad news and that might also explain why the inflation effects are dominating the classical safe haven bullish response. Meanwhile, let's not ignore that the underlying macro landscape continues to show signs of improvement with Monday's PMIs all at or above consensus. But given the uncertain path forward with Iran, we doubt risk sentiment can make a more sustained recovery in the next few days, which should keep weighing down on the back end of the curve.

Tuesday's events and market views

With all eyes focused on inflation risks, the eurozone CPI numbers for February will be closely watched. Consensus sees the core number stable at 2.2%, and headline inflation remains below target at 2%. In this environment, the market reaction will likely be asymmetrical whereby an upside surprise would have more impact than a downside surprise.

We expect headlines to stay the main drivers of market moves, with oil prices the key variable to watch.

We have plenty of eurozone supply to digest, including two syndications. Austria will have a 30Y and 3Y (green) syndication for a total of c.€7bn, and from Germany we have a 15Y green twin bond for an estimated €5-6bn. In addition, we have the Netherlands with a €6-7bn 10Y DSL auction, and Germany will auction 5Y Bobls for €bn.

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