Rates Spark: Day Two And The Pendulum Swings Again

(MENAFN- ING) Markets decide that Monday's calming was a tad premature. What now?

We remarked on Monday's notable calming in market circumstances, as volatility dipped, bond yields rose and risk was put back on again. A lot of that completely reversed early Tuesday, and even though there was something of a subsequent calming as the day progressed, a more menacing tone obtained overall. We're left with the impression that the markets want this movie to play out a bit more before taking a conclusive stance. That's probably fair.

Ahead, we risk seeing bouts of flight to safety, pushing yields down. Don't rule out a break back below 4% on the US 10yr, even if brief, likely on a risk-off episode should things turn really sour. This could see the 10yr Bund yield trekking back towards 2.5%. But as we look into the second quarter, we anticipate the US 10yr yield to get back up to the 4.3% area (a level that obtained for a period in January). That equates to the German 10yr yield getting back up to the 2.9% area. This reflects a resultant higher inflation narrative (higher energy prices). Beyond that, a subsequent calming in yields through the second half of the year would reflect the payment for that in terms of a hit to real growth. That's the way we see it for now, and we'll update as we progress through an uncertain number of weeks ahead.

And for the Federal Reserve, the timing of the Warsh rate cuts will be pressured towards a wait. But they should still ultimately come, so long as medium-to-long term inflation expectations remain contained.

Carry trades can suffer in a more volatile environment

Markets are still calibrating to the new environment, and we think the uncertainty in monetary policy, especially, can have wider implications. Euro rate markets were enjoying a long period of very low volatility, even while equity volatility was on the rise. Suddenly, the“good place” of the ECB is being challenged, and we doubt we will see that resolved in the very near term. On Monday, markets still held a bias towards easing, but on Tuesday the narrative shifted and markets briefly priced in a 25bp rate hike of 50% in 2026. Our baseline is still that market conditions should normalise in a few weeks, but a prolonged period of soaring energy prices remains a realistic possibility. Iran has already shown that just a few drones can have a material impact on global oil prices.

The possibility of ECB rate hikes poses a serious risk to carry trades and could trigger a significant widening of eurozone government bond (EGB) spreads. The very tight spreads we've observed in EGBs over the past months were not due to a sudden fiscal improvement or a betterment in the supply picture. Instead, we argued just last week that the tightening of spreads was linked to the very favourable carry conditions given stable funding costs. Short-term borrowing to fund long-term bond positions gave a handsome return for relatively little risk. Leverage could even enhance returns further. Now that environment is changing and uncertainty in future funding costs can force investors to unwind such positions. In effect, we could see significantly more widening if ECB rate hikes remain on the table.

Rates volatility surged well before first ECB hike in 2022, alongside wider spreads Wednesday's events and market views

From the eurozone, we start the day with Spanish and Italian PMIs, which would often get plenty of attention but are unlikely to make a big difference this round amid all the geopolitical headlines. Other key data are the eurozone PPI and unemployment figures. Unemployment is expected to remain stable at around 6.2%, still at record lows. The US data includes the ISM services index for February. Consensus sees a still strong 53.5 for the headline index, but also a relatively high prices paid component of 67.8. Also, the ADP employment numbers will be watched closely for any signs of labour market weakness.

In terms of supply, we have Italy continuing with their 6Y retail bond for an estimated uptake €15-18bn this week. Germany will auction a 7Y green Bund for €1bn.

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