Rates Spark: Divergent paths

Risk sentiment puts a brake on bull-steepening reflexes

Risk sentiment, judged at least by stock market performance and credit spreads, appears to be further on the mend following last month’s banking turmoil. The read-across for rates is a moderate bear-steepening via the long end as classic safe havens underperform. At the same time recovering risk sentiment can keep a brake on bull-steepening reflexes taking hold as it limits the desire for now to price in more aggressive cuts in the not too distant future. Eventually we think these will be the main drivers of any larger re-steepening.

Yesterday’s data did provide further hints that the Fed is close to the end of its tightening cycle. The initial jobless claims rose further above 200k indicating that the sizeable layoffs that made the headlines earlier in the year are starting to show up in the data. Producer prices decelerated a tad more than markets anticipated, even if overall levels remain outside the Fed's comfort zone.

The system is slowly weaning itself off from the central bank life-line

More relevant to set a curve re-steepening in motion are clues with regards to the actual degree of additional financial tightening triggered by the banking turmoil and its impact on the real economy. For now the Fed's data on discount window borrowing suggests that the system is slowly weaning itself off from the central bank's life lines. In the latest week even the borrowing via the Bank Term Funding Program declined for the first time. However, inflows into money market funds, which are seen as a counterpart to bank outflows, continue albeit at a slower pace.

Emergency borrowing from the Fed gradually eases

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Deposit flight eases but credit contraction is now the main worry

The above data suggests some tentative easing of tensions, but markets will keep an eye on actual bank deposit flows. The Fed’s official data will be released tonight. It comes with a two week lag, but more crucially it does not offer the full granularity to gauge flows from smaller banks to the few large systemically relevant banks – so far there have only been limited anecdotal reports. The first quarter results of JP Morgan today should offer a more concrete data point.

The Fed is rearranging the deck chairs on the Titanic heading towards a credit crunch iceberg

More attention should also be paid to the asset side of the Fed's weekly data release on banks balance sheet. The last two weeks of March saw banks pull lending back, presumably in response to financing stress. Commercial real estate and small lenders are particular worries and another week of lower lending would reinforce the market, and our, conviction that the US economy's woes will be exacerbated by a credit crunch.

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Policymakers are still discussing whether to hike at the May meeting, in all likelihood they will as current inflation still runs hot and too much uncertainty still surrounds the outlook. But markets are seeing this more as the Fed rearranging the deck chairs on the Titanic heading into the credit crunch iceberg.

EUR long-end rates are still sensitive to the ECB's next moves

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Discussions ahead of the May ECB meeting get a hawkish tilt

The debate of near-term policy moves remains more relevant for EUR rates markets. There is still a clear read-across to long end rates from the ECB interest rate outlook for the next few months. Central bank officials have started to give the discussions ahead of the May ECB meeting a hawkish tilt with the debate now clearly between a 25bp or 50bp move. That also gives market rates some room to move higher with 29bp prices, i.e. so far only a 20% chance for larger 50bp hike and in turn could drive further underperformance of EUR rates versus the US.

The debate of near-term policy moves remains more relevant for EUR rates markets

Mind you, a larger move is not our base case, but that does not mean markets cannot lean towards a larger move in the meantime. The ECB’s Holzmann continues to beat the drum for a 50bp hike. Latvia’s Kazaks saw no need to slow down hikes as inflation remains persistently high. More measured tones came from Slovenia’s Vasle. Banking tensions have subsided and rates will have to rise further in his view, the choice being between 25bp and 50bp. While it is too early to decide now, he indicated that the key to a smaller rate increase would be a turnaround in the core inflation trend. This gels with an earlier Reuters report that put emphasis on the April inflation data and the bank lending survey that will become available shortly before the May rate decision.  

Today's events and market view

We have seen a moderate US curve steepening yesterday, but not yet of the kind which we think will be the driver of the next steepening leg. This will occur when markets are free to price in cuts. Markets are already eyeing them, but for now the Fed is still busy pushing through one final hike.

Today’s data releases remain US focussed with retail sales, industrial production and University of Michigan consumer sentiment survey. The latter includes surveyed consumer inflation expectations.  For a market still grappling with the potential fall-out of the banking turmoil, the Fed’s data on deposits and lending, as well as crucially upcoming banks’ quarterly results will help judge to what degree the wider banking system has been affected.