Rates Spark: A Short Drop Within An Uptrend

The resurgence of geopolitical tensions has revealed how different sectors of rate markets react to tail risks. Long-end rates have more leeway to adjust lower, but the trend is clearly in the other direction, upwards. Euro front-end rates have been happy to diverge from their US peers, also helped by a barrage of dovish ECB comments.

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Curve flattening in most market configurations

Given the magnitude of the recent rise in traded interest rates, a casual observer would be forgiven for concluding that tail risks, such as an escalation of geopolitical tensions in Ukraine, present an asymmetric risk to interest rates to the downside. We think there is some truth to it but this statement needs qualifying. Some Fed speakers have already come out to dispel any impression that tensions would put them off rate hikes, and the short-term impact on inflation from even higher energy prices would send shivers down the spine of central bankers already losing sleep over inflation.

EUR 2s10s failed to follow its peers into flatter territory

Source: Refinitiv, ING

This means that, more than ever, the conventional wisdom that curves would flatten in a risk-off environment is likely to prove correct. We agree that any snap-back lower in long-end yields could be violent, but we would frame it as a temporary move within a more significant upward trend in rates. Our call is still for 10Y Treasuries to touch 2.25%, and for 10Y Bunds to converge to 0.5%.

Euro rates, closer to the action

If that dynamic is well accepted in USD rates, it is harder to discern in EUR. Perhaps due to the Eurozone’s proximity to Ukraine, short-term yields have been reluctant to price more hikes in the face of greater geopolitical uncertainty. This is understandable. A protracted conflict would mean higher energy prices but would also add weight to the thesis that higher prices will ultimately harm consumption and prove deflationary. It would take a dramatic escalation for this to become the market’s mindset, but this is the main scenario under which EUR and USD rates could meaningfully de-couple in our view.

EUR rates are more vulnerable to geopolitical tensions in Ukraine

Source: Refinitiv, ING

This reluctance to follow US rates higher can also be explained by the barrage of ECB speakers leaning against the most aggressive rate hike expectations. More than anything, officials seem to want to keep their options open, and to prevent too damaging an adjustment higher in rates. Geopolitical tensions have lent their comments some credibility. An added benefit should in theory be to ease fears in peripheral markets of an abrupt policy tightening, but it hasn’t played out this way so far.

Today’s events and market view

The Zew survey’s expectations component will be the main forward-looking flashpoint on today’s calendar. The effect on markets might be lost amid the flurry of Ukraine-related headlines. Other releases include preliminary (ie, second reading after the advance print in late January) 4Q Eurozone GDP.

Villeroy, of the Banque de France, is due to speak. A lot of ECB speakers have tried to take the edge off the February hawkish shift, so the ability for new comments to surprise is limited.

The Netherlands will launch a new 10Y bond via auction raising €4-6bn, and Belgium mandated banks for the launch of a new 30Y via syndication which we expect to price today and amount to up to €5bn. Germany is also part of today’s line-up with a €4bn 5Y auction. This week's supply is challenging but risk aversion means its effect might not be felt on outright rates. Instead, we look out for pockets of underperformance in the sectors affected.

In US hours, PPI will be the main release with market-moving potential given the sensitivity around last week’s CPI print. Empire Manufacturing is the main sentiment index to watch.