(ING Global Economics Team)
Current market themes have crystallized around the US CPI release. The market swings were a testament to elevated short-term volatility while the data itself does not stand in the way of rates ultimately converging lower, in our view. Most notable was the narrowing of the UST Bund spread, where more could be in store as the ECB recovers its hawkish poise.
The Fed minutes nod in the direction of tighter lending conditions being a material factor
It’s clear from the Fed minutes that the recent turmoil in the banking sector matters. And so it should, especially as history shows that material tightening in lending standards typically ends up with a recession and higher unemployment. And that combination typically results in eventual interest rate cuts and a much steeper curve.
The part of the curve bucking the re-steepening trend right now is the 2/5yr, which is in fact re-inverting, re-richening the 5yr on the 2/5/10yr fly. So the belly of the curve is getting richer. But this is more a reflection of quite low long-tenor rates, relative to where the fund’s rate is pitched. Our analysis shows that current 10yr yields are fully discounting a move back to the 2.5-3.0% area for the fund’s rate in the coming 18-24 months.
That reverse engineer a period of macro pain ahead, and the Fed won’t cut for the fun of it. And the tight lending standards and banking troubles are the catalysts. A 25bp hike is getting discounted for May, just about, but that really should be it. Then the front end will really start to discount cuts ahead, re-steepening the curve.
The re-flattening of the US 2s5s curve is at odds with an imminent end of the Fed’s hiking cycle
Looking for lower rates beyond the near-term volatility
The US CPI was seen as one of the key data points to determine the Fed’s next steps. It wasn’t so much the pricing of the May hike chances that were impacted. These were relatively stable surrounding a 75% probability for a 25bp given a core rate still running hot at 0.4% month over month.
US CPI data has cleared the path for rates to converge lower
It is the price action in longer tenors surrounding the release that has crystallized some of the main themes of current markets. For US rates the CPI data has further cleared the path for rates to converge lower going forward. Digging into the components of the CPI data showed some encouraging evidence of a slowing trend in the rate of price increases, which should allow the Fed to step down its hawkishness on inflation and zoom out on the broader picture. According to the March FOMC minutes, Fed staff have made a mild recession part of their baseline scenario now, though they note a higher degree of uncertainty surrounding this outlook, crucially depending on how the banking tensions would evolve. For now, the situation there has stabilized, but going forward this conditionality can still be cut both ways.
The size of the market swings, top to trough almost 20bp in the 2Y and almost 10bp in the 10Y US Treasuries, is a testament to the elevated short-term volatility markets still have to go through as they grapple with central banks on the verge of calling an end to their hiking cycles and the substantial uncertainty surrounding the magnitude of the economic fallout from the recent banking turmoil. Ultimately, we think the case for faster rate cuts by the Fed and for 10Y rates to converge to 3% has only strengthened.
The convergence in dollar and euro yields accelerates
… and more convergence between US and EUR rates The other important market theme that has crystallized surrounding the CPI release is that of further convergence between US and EUR rates – while the UST curve bull steepened, the Bund curve bear flattened. The 10Y UST- Bund spread has briefly dipped below 103bp during yesterday’s session, an impressive 9 basis points of tightening.
Limited banking fall-out has allowed ECB officials to focus on sticky core inflation
In contrast to the US, the European Central Bank is finding some comfort in the fact that financial stresses have remained relatively contained in the euro area. Prospects of limited banking fall-out have allowed ECB officials to refocus their attention on the issue of sticky core inflation again. It is noticeable that even herswhile doves such as VP De Guindos seem to be on board with this message.
Hawks like Austria’s Holzmann have reiterated their calls for another 50bp hike in May. He also flagged the possibility to speed up the process of quantitative tightening in the second half of the year given how well markets have coped with the reduction of the ECB’s balance sheet thus far. But also more moderate members such as France’s Villeroy have signaled the possibility of further hikes – in the plural – noting inflation has become more broad-based and potentially more persistent.
Markets are adjusting their hike expectations higher. They are now fully pricing in a peak ECB deposit rate of 3.75%, i.e. the ECB will deliver another 75bp of rate increases between now and October. The 10Y Bund yield was not immune to the initial drawdown in yields surrounding the CPI release but ended the session 7bp higher.