Rates Spark: Flip The Gaze From China Back To Iran

(MENAFN- ING) Treasuries on a holding pattern, but still tilted with an upside bias to yields

President Trump's China visit is ongoing and offering a welcome break from Iran war angst. But that is what we are going right back to. The implications of the Iran war for US inflation have been clear in the past few days of releases for April, and while it's not the best barometer of the war effect, export price inflation of 8.8% year-on-year is a scary enough number to at least ponder the implications of. We're in May now, and every day adds to the pressure, and will continue to ratchet for as long as the stand-off persists.

The US 10yr hit 4.5% on Wednesday. Blipped up there in fact. And immediately got bought. We know 4.5% is a buy level. We've talked to investors globally, some of whom don't pay huge attention to Treasuries, but hold them. And for most, 4.5% is a bliss level to get in at. Just as 5% is for the 30yr. So there is a bit of that in play. Ultimately, the 10yr yield managed to get down to below 4.45% early Thursday, but then edged higher through the US afternoon. The 4.45% area with an eye on an attack of 4.5% remains a defensible view ahead.

Even though 4.5% on the 10yr is typically a buy signal, the opposite dynamic can also apply. Should the 10yr yield manage to break above 4.5%, it could implicate a spiral to uncomfortable levels. This is a risk that remains front and centre, as we remain in a holding pattern on the Iran war and the shuttering of the Strait of Hormuz. It seems that the US strategy is to wait, and allow the pain to build within Iran. The thing is, that too inflicts pain domestically for the US. Not as much pain, more of an inflation irritant, but still a negative tilt for markets and the economy.

That negative tilt is being muted by the extraordinarily upbeat tone in the tech space and the ongoing AI revolution. There is a productivity dividend coming from this, which has an inflation containment element to it. And there is an elevated nominal GDP element to boot, which helps tame the debt/GDP spiral narrative. But still, the front and centre issue is delivered inflation, which remains troubling from a Treasury market perspective. We maintain a viewpoint centred in an upside test for yields in the weeks ahead, until or unless we know more.

Euro rates stable in the very near term but face an uncertain outlook

Euro rates seem to have entered into a holding pattern, trading in relatively tight ranges, especially the long end. The 10Y euro swap has been stuck between 3.0% and 3.1% for most of the past two months, and we see that range as a reasonable handle for longer. We do, however, see that longer-term inflation swaps have been drifting higher, but this has been offset by a compression in real rates.

We could see euro real rates fall more sharply if risk sentiment were to worsen, but as US equities are hitting new records, that doesn't seem imminent. We do, however, think the eurozone growth outlook remains fragile. PMIs and broader economic data surprises both point to a significant risk to the economy from the ongoing geopolitical turmoil. As such, the belly of the curve could see more outperformance if markets turn more negative on medium-term growth.

The 2Y point on the curve remains fully driven by oil price moves, now pricing in three 25bp hikes over the next year, more than we have pencilled in currently. Until we have a better view on potential second-round effects, we don't see short-end rates deviating from the tight relationship with oil prices. And we think oil prices could remain around current levels, because even if a deal were to be struck, supply constraints will keep prices elevated.

Friday's events and market view

A relatively quiet agenda. In terms of data, we have the US publishing the Empire Manufacturing Index for May, which consensus sees weakening from 11 to 7.3. We also have US industrial production data for April.

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