Rates Spark: What really happened yesterday and will it reverse?

(ING Global Economics Team)

Either markets are not listening closely enough, or they are, and see only one way for long-end rates. We get that. Weak data should result in a nudge lower in market rates. But here, US long-end rates in particular look stretched to the downside versus the funds rate. Next cue from payrolls.

The rally makes sense at the front end, less so at the long end

Front ends are clearly positioning for a change in the rates cycle. The implication here is central banks are practically done, and the follow-on is next big moves, beyond final hikes, are down, especially for the US. That’s fine. Typically 2’s will average out the path of the official rate in a coming couple of years, and should broadly break even against that profile. If you look at the profile of the future for the Fed funds rate it gets to 3% in the next 18 months. If that’s realized, the straight average over the coming two years is 4.05%, pretty close to the current 2yr yield. We have a lower bottom for the funds rate at 2.5%, so in fact, that can go lower, below 4% and towards 3.75%.

falls in long rates will continue to loosen financial conditions. That’s a problem for the Fed

The bigger issue is the 10yr. It’s now at around 3.4%, and at 175bp through 6mth Libor. It has never been stretched further than this over the past four decades. Based on that there should not be huge room to the downside for the 10yr yield. That can change when the Fed stops hiking. But the Fed is still hiking, and even as they hike, financial conditions continue to loosen. The Bloomberg measure suggests that financial conditions are loose in absolute terms. And while Chair Powell brushed this off at the press conference on Tuesday, the reality falls in long rates will continue to loosen financial conditions. That’s a problem for the Fed, or it should be.

So, the rally on the front end is fine, as even as the Fed hikes more, that can also mean bigger subsequent cuts. The back end makes less sense, apart from the simple logic that data confirming easing inflation pressures needs to be rewarded by another nudge lower in yields. We wouldn’t be doing our jobs if we did not point out that long-end rates are stretched like a spring that could easily snap back.

The same can be said of credit spreads, and wider risk assets though, which further complicates the direction of market rates. Can everything sell off at a certain point? It’s happened before.

Long-end dollar rates are sinking deeper below the front end

US jobs data key to validating the rally

This week has also pitted central bankers against the data. And it appears that markets are taking their cues more from the latter, seeing the central bank meetings as a final hurdle that a broader market rally in rates had to overcome. And, after all, central banks see themselves as increasingly data dependent these days.

By itself 190k should be still too high for the Fed, but likely low enough for markets

This narrative culminates in the US jobs data release today. Employment creation remains strong for now. Jobs openings data this week pointed to another increase, contradicting the increasingly frequent anecdotal stories of job layoffs, and the jobless claims data looked equally robust this week. But it seems only a matter of time before the job market will start to show its first cracks. The ADP payrolls estimate pointing to 106k fits the narrative, though it hasn’t nudged the consensus for today’s number below 190K.

By itself, 190k should be still too high for the Fed, but likely low enough for markets. It is too high to give an all-clear on inflationary pressures and justifies a Fed stance where more hikes are still to come. But with the markets inherently forward-looking and in extrapolating mode it would take a notable upside surprise in today’s jobs data to turn around market momentum.

The ECB undid one year of struggle to keep real rates positive in one day yesterday

The ECB’s feeble pushback fails to impress

The European Central Bank hiked by 50bp and committed to another 50bp increase in March. By ECB standards that are already hawkish. But as the ECB said it will “then evaluate the subsequent path”, that firmer commitment does not stretch beyond the next meeting. This would have been necessary to counter a market that is increasingly pricing in rate cuts for late 2023 to 2024, bringing along the easing of financial conditions that is counterproductive to the ECB’s main goal of bringing down inflation.

The market rally yesterday was mainly a drop in real yields. It had taken a concerted communications effort ahead of the meeting to lift the 5Y real ESTR OIS rate to 40bp. It has now dropped back to 20bp. While still well above pre-December levels of -40bp we doubt that this sits well with the majority of the ECB’s Council and we may well see post-meeting attempts to straighten the hawkish record.

Reuters reported after the decision that policymakers are seeing “at least two more hikes”, but the caveat is again that the Council is a diverse group and “differences remained about their pace and final destination”. Against this backdrop, the ECB may struggle to decouple longer EUR rates from a broader rally led by the USD and GBP, where central banks are closer to their cycle peaks. But we think a relative underperformance/rise of EUR rates is still probable. And remember, ECB policy rates are still some 200bp below the Fed’s and 150bp below the Bank of England’s.

Risk assets are large beneficiaries of the ECB lacking hawkish teeth. The 10Y BTP/Bund spread tightened by 19bp and is approaching the 180bp mark again. The ECB’s detailed parameters for reducing its asset portfolio yielded little surprises with a proportionate approach to reinvestments being taken. But there had been some speculation that the ECB would rebalance the PSPP portfolio towards Supranationals in the context of “greening” the portfolio. Some contemplated even that the ECB might already hint at increased amounts for later in the year. In hindsight, perhaps a sensible option given the weak perception of rates guidance. At the margin, both would have been detrimental to government bonds and sovereign spreads.