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An economy that is, for now, neither too hot nor too cold, benefits risk sentiment but not government bonds. Rates volatility cannot fall for very long when yields are rising. Data and Fed judgement on the risk of a credit crunch will be key
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Rates are vulnerable to an uptick in inflation
Calm has set in for rates markets, and the result is an improvement in risk appetite that has so-called risk-free rates reprice higher, but implied volatility lower. News over the weekend, primarily the decent US jobs report, isn’t sufficient a reason to explain the roughly 20bp sell-off in 2Y US Treasury yields between Thursday and Tuesday closes in our view. Worse still, for German 2Y, that figure is almost as large - around 17bp against a backdrop of arguably no new developments for Europe.
A lack of clear progress on the inflation front may push the market to doubt some of the cuts priced for this and next year
Heading into today’s US CPI, yields do appear vulnerable to a retracement as the dollar swap curve implies just under 50bp of Fed cuts this year from current spot fixings, and almost 75bp from their peak rpiced for May or June. The odds of a May hike are over 70% which chimes in with our own forecast, but we think markets still underestimate the speed and extent of cuts once the Fed decides it has won its fight against inflation and that the economy needs support. For now, however, a lack of clear progress on the inflation front may push the market to doubt some of the cuts priced for this and next year.
The upshot is that rates are still stuck within their post-Silicon Valley Bank trading range. 4.2% is currently the top of that range for 2Y and US yields could conceivably jump to that level on a surprise uptick in inflation. This would be equivalent to the 10Y jumping to 3.5%. Looking at current correlations, this would only necessitate the swap curve to price out 10bp of Fed cuts this year.
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2Y and 10Y Treasuries don't appear to require much more in Fed cuts being priced out in order to move to the top of their recent range
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It is hard for rates and volatility to move in opposite directions, even with a goldilocks economy
However, we have a greater conviction that this would set rates up for a subsequent fall to 3% later this year as most of the data published now doesn’t reflect yet the hit to lending caused by the US regional bank crisis. The fall in deposits and in lending in March should be proof enough that the effect of banking stress, and more broadly Fed tightening, is making its way into the economy. So is the National Federation of Independent Business survey respondents reporting low loan availability. The March Fed minutes released this evening may shed some light on the its assessment of credit crunch risk.
Risk appetite is still healthy, but not appetite for government bonds
The result is a reverse goldilocks market where economic data, viewed through rose-tinted glasses, can be seen as resilient and where inflationary pressure, although still elevated, is easing. Back in January, this not too hot (to be inflationary) nor too cold (to stoke fears of a hard landing) economy caused a rally in assets across the risk spectrum. Post-SVB, just as one would think rates upside has been capped by banking stress, risk appetite is still healthy, but not appetite for government bonds. We think this state of play is inherently unstable. Either data continues to surprise to the upside and the rise in rates is validated, but at the cost of higher rates volatility, or the slowdown accelerates which will bring rates down, to 3% for 10Y Treasuries, and around 2% for 10Y Bund.
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Higher US yields could bring higher volatility, unless low volatility drags yields down
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Today's events and market view
The is a long list of potentially market-moving releases today and almost all of them will come from North America. First, the US CPI report is expected to show that the monthly core measure remained stubbornly high in March at +0.4%, too hot for comfort for the Fed which could tip the scales in favour of a May hike.
Read next: The Commodities Feed: All eyes on US CPI| FXMAG.COM
On the central bank front, the Bank of Canada is expected to keep rates unchanged for its second meeting in a row. This will be followed by the minutes of the March Fed meeting where the central bank decided to hike 25bp despite spreading regional bank stress.
Also in North America, the IMF meeting in Washington will see a number of public appearances, for instance from Bank of England governor Andrew Bailey.
Prior to this, the European session will be filled mostly by bond supply, in the form of 13Y linkers from the UK, and bonds in the 30Y sector from Germany.
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