Rates Spark: Diverging Trajectories

The widening of USD-EUR rate differentials continues apace, reflecting dramatic growth and budget divergence in 2020. There are risks to this trend, but most will manifest themselves after the US election. EU SURE funding kicks off today.

Source: ECB, ING

Overnight: still tightening

Even in a relatively small economy, the announcement that non-essential shops in Ireland will remain closed for a period of 6 weeks will do nothing to alleviate the covid angst gripping European markets.

Conflicting soundbites came out of Brexit and pre-election US stimulus talks overnight. We expect the latter is considered too low a probability to meaningfully move markets.

Wider Treasury-Bund spread; a tint of positivity

Even as equities go risk-off, US market rates are testing higher. That is a marked change from the persistant anchoring of US market rates in the previous month as equities were predominantly risk-on. It is notable that US market rates are also resisting the pressure coming from core Eurozone market rates to move back lower.

In consequence, the gap between longer tenor US and Eurozone rates continue to drift higher (wider Treasury-Bund spread). This is not a bad thing; it is indicative of a better prognosis for the US, but that is a necessary requirement for overall (global) recovery. This is the case as the US typically leads recoveries, eventually.

We have a tough winter ahead as Covid concerns dominate again, but a wider Treasury-Bund spread at least shows that the US maybe can show the way forward in a reflationary sense in due course. At the very least it is a cushion versus the angst that deep negative core Eurozone market rates are discounting.

USD-EUR divergence to continue until the election

The EUR-USD divergence continues to play out in rates markets at an even faster pace than we anticipated. By now it is evident that our call for the 30Y swap rate differential to return to its pre-Covid 19 level of 138bp before the US election is too conservative. We would not be surprised if the move accelerates after Thursday’s debate, provided Trump fails to trip Biden up, and pushes towards the end-2019 level of 146bp.

There are a number of risks to this view. As we mentioned above, an ‘October surprise’ could reverse the Democrat’s lead and have markets price out the odds of a ‘blue wave’ outcome. More likely in our view, the pre-election market move could exceed what can reasonably be expected from the new administration in terms of pro-growth policies, making post markets ripe for a wave of profit-taking.

We are also increasingly wary of a repeat of 2016 where markets changed their assessment of Trump’s policies on the day following the election. In that scenario, the USD curve could remain steep on greater growth and inflation prospects but outright rates would fail to take off as a cocktail of policy uncertainty for some sectors, and higher taxation for most would push investors into the safety of the US Treasuries, at least temporarily.

Mostly a reflection of diverging fiscal and growth trajectories

There could also be some economic news that chips away at the current narrative of US outperformance in the covid recovery. The most likely driver this week would be a further deterioration in jobless claims numbers. There could also be a move to tighten restrictions in US states to stem the spread of covid, although we note that the US ‘summer wave’ failed to leave a noticeable dent in USD financial markets.

Pending more clarity about next year’s policy mix, we feel markets will continue to reflect the yawning gap between US and European economic paths. At the risk of oversimplifying, the US will rack up a deficit of 16% of GDP this year, almost twice the Eurozone’s, whilst the US recession will only be around -4%, half the Eurozone’s. This is enough in our view to justify the rate differential at the long-end reverting to its late 2019 level.

EU funding kicks off with a 10Y/20Y dual-tranche deal

Long and eagerly awaited, the EU mandated banks for its first SURE-related funding transaction yesterday. It will be a 10Y and 20Y dual tranche deal which is widely anticipated to price today.

So far over €87bn of loan applications have been approved by the EU for its instrument to provide temporary Support to mitigate Unemployment Risks in an Emergency (SURE). Pending further approvals, up to €100bn will have to be funded before the end of next year. Up to €30bn may raised by the end of this year.

In light of the overall large volumes that need to be raised, not just for SURE but also the €750bn EU recovery fund (NGEU) starting later next year, we could imagine that the EU will want to send a strong signal with its first transaction. Launch sizes of €5bn for the 10Y and at least €3bn for the 20Y bond should be feasible. Judging from past transactions in the sovereign and supra space market demand is healthy, and the transaction’s social bond tag should only add to it.

All EU SURE bonds are sold under a social bond framework, within a 3Y to 30Y range and with an average maturity target for the overall issuance of 15Y. All issuance for SURE will be via syndicated deals with minimum target sizes of €3bn to €5bn, but this does not preclude the form also using an auction model to fund the NGEU.

ECB has saved it PEPP ammo over the summer

Source: ECB, ING 

The possibility of also larger supra purchases by the ECB should help markets take down the rising flood of EU issuance. Since early summer the ECB has continued to spend less per week on purchases via its pandemic emergency programme (PEPP) than it would take on average to fully spend the €1.35 trillion by the end of June 2021 (see above chart), i.e. well below around €20bn per week. And amid low overall volumes, the share of supra purchases has been particularly small as well. Over the months of August and September, where a detailed breakdown is available, supras accounted for only 4.6% of public sector purchases (€5.8bn in absolute terms). In comparison, under the public sector purchase programme (PSPP) the ECB aims for a share of 10%.

Today's events: 2Y German auction, US housing data, and Fed speakers

The data calendar is light today. The focus is on US housing data, which should continue to show this sector as a key growth driver. We will also see a couple of Fed speakers, such as Quarles and Evans.

Following yesterday's multiple appearances, the schedule on the ECB side is lighter today with only Spain's Hernandez de Cos slated to speak. Still, the coming few days are the last opportunity for ECB officials to go on the record ahead of the ECB meeting next week. 

In the primary market, the highlight is the EU transaction, but Germany is also scheduled to sell €4bn in 2Y bonds.