Rates Spark: Bonds Not Being Bullied By Equities

Even as equities sold off yesterday, bond yields did not fall by much. The bond market is still sniffing a (slightly) better medium-term outlook, especially in the US. This week has brought temporary setbacks to our USD-EUR rates widening view, and to our expectation that peripheral sovereign debt would lag into the ECB meeting. We look at the causes.

Source: ECB, ING

The US 10-year holds on to the 80bp area

It's been quite an interesting battle between equities and bonds. For months, equities rallied while the bond market saw nothing but despair, and yields remained anchored. In more recent months, the bond market has identified a better outlook, while equity markets have struggled.

From a bond market perspective, yields are off their highs lately as equities struggle, curves are flatter and the Treasury-Bund spread is off its recent wides. But, the key thing is that US 10yr yield is still clinging to the 75/80bp area, and thus still a 20bp uplift from where its lows. The bond market remains priced with a big angst discount but is not reverting to prior levels angst (SPTL).

That is a good thing, and we'd doubt any significant flattening or Treasury-Bund spread tightening can be sustained.

USD-EUR rate widening: Pre-election profit-taking?

Price action this week has cast a doubt on some of our high conviction views. Firstly the strong outperformance of USD rates compared to EUR (FXE) marked a clear setback in an otherwise almost uninterrupted trend. Going through the list of potential culprits, it was not obvious that sentiment was weaker in the US than in Europe, judging from the relative performance of their main stock market indices.

Technical factors are unlikely to receive much of the blame either, given that US Treasuries see supply this week, albeit of relatively short duration. European rates on the other hand see not only light supply, but coupon reinvestment and duration extension should prove beneficial. Our tactical -0.70% yield target for 10Y Bund yield appears far away despite these supportive factors.

One last, if unproven, potential driver could be that the pre-election Joe Biden reflation trade meets an early end.

If we see no reason to expect a reversal of fortunes in the presidential election, one or two Senate seat difference from current forecasts have the potential to overturn the ‘blue wave’ narrative of a Democratic-held Congress shifting fiscal policy to a higher pro-growth regime. Those who called the market correctly into the vote might well decide to take profit before results start pouring in.

Sovereign spreads: Don't get too excited

Another development has been the strong performance of peripheral sovereign debt, on S&P raising the outlook on Italy’s rating last Friday. The knee-jerk reaction is understandable on account of the surprise, although we expect risk appetite to remain subdued into Thursday’s ECB meeting. In fact, as the meeting approaches, we find that the risk of confusing or even contradictory communication rises.

With almost unanimous expectations, including ours, of a QE boost in December, we fail to see how the ECB could deliver a dovish enough message to validate them on Thursday. Higher-volatility fixed income markets, the ones depending the most on ECB intervention to sustain their pricing, appear most at risk.

We expect sovereign spreads will ultimately find a base but for now, further widening of the 10Y Italy-Germany spread, to 140bp in the near-term, is warranted.

In the meantime, the ECB is also keeping its powder dry within its existing asset purchase frameworks. Weekly net purchases under the pandemic emergency programme (PEPP) rose slightly to over €16bn in the past week.

With €733bn left to spend under the PEPP envelope until mid next year, the currently lower volumes leave more room for larger interventions further down the road, or an extension of the PEPP horizon without increasing its size.

Today's Events: US durable good orders

Economic releases will be few and far between in the European morning. The US durable good orders will be the main data point fo note.

Bond supply for the week gets underway today with Italy will selling linkers and zero-coupon bonds (up to €3.25bn). The US Treasury will sell 2-year notes.