Unlikely Vote of Confidence: Examining Curve Inversion and Central Banks' Stewardship Amidst Resilient Economies

An unlikely vote of confidence on the economy and central banks' stewardship

Curve inversion is a very natural phenomenon when the front end rises. It reflects the fact that the market collectively forecasts rates to subsequently fall back towards their long-term average. There are a lot of assumptions in this reasoning. One is what is the correct long-term level for rates, another one is how long it takes for them to drop back to, or below, this level. For the curve to steepen near the peak of a hiking cycle, which we think will be reached in July and September for the US and eurozone respectively, markets need to assume that no cut will follow, or indeed that there could be more hikes down the line. This, in other words, is a massive vote of confidence in both the economy’s strength, and on central banks’ ability to find exactly the right level of rates that slows inflation but not the economy, assuming such a thing exists.

 

The recent resilience of the US economy makes this narrative slightly less unlikely than thought earlier this year, but it remains a stretch. More likely, by pushing the expected start date of the Fed’s cutting cycle further out in time, it makes bets on falling long-end rates less attractive for investors with a shorter investing horizon, especially into this week’s long-end US Treasury auctions.

Today’s Zew survey should, if consensus is any guide, confirm that no such optimism exists in Europe. To us, the risk of a protracted fight against inflation is real, but we doubt this is what has steepened yield curves since the start of the month. More likely, lower rates bets are losing in popularity and the very inverted yield curve levels a week ago made a snap back more likely. We reserve our judgement on a more macro-related bear-steepening, but we’re sceptical that the necessary optimism exists.

 

 

Today's events and market view

The main economic releases of note this morning are Italy’s industrial production and Germany’s Zew sentiment survey. Regarding the latter, both the current conditions and expectations components are forecast to decline, in line with the general gloom in the eurozone, if Bloomberg consensus is any guide. The National Federation of Independent Business small business optimism in the US completes the list.

There will be plenty of 7Y core bonds on offer, with the Netherlands and Germany both issuing today. Greece has also mandated banks for the launch of a 15Y benchmark via syndication. This will coincide with a tender offer for 2Y and 3Y bonds.

In the US, the treasury will begin this week’s supply slate with a 3Y T-note auction.