Rates Spark: Gimme Five

We've had a brief look at 5% on the 10yr yield. Now we wait for the Fed. Logic would suggest that a rate hike should calm the back end. However, the back end is super flighty. Delivery of a 25bp hike in a way validates what the back end has been doing in the past number of months, and in that sense could just as easily be an excuse to break back above 5%, and keep on going

The good (productivity) the bad (issuance pressure) and the ugly (Iran war and inflation)

Chair Warsh will be very aware that the 10yr Treasury yield is looking for an excuse to mark at 5% again. A 25bp hike could or should help. That said, whether the Fed hikes or not, the 10yr yield is liable to test 5% again. It’s up there mostly on account of higher real yields, in fact. There is not much the Fed can do about that, to the extent that it reflects productivity growth expectations (the good), wider issuance pressure (the bad), or the evolution of the Iran war’s effect on oil prices (the ugly).

There has been a lot of market talk that a break above 5% on the US 10yr yield would be pivotal, and would generate macro and debt dynamic pressures. But there is nothing mythical about 5%. We view it as no more than a 50bp concession on top of the neutral value zone of 4% to 4.5%. It does, of course, pressure mortgage and other funding rates higher, which presents macro pressure. And debt dynamics worsen to the extent that the Treasury continues to finance in long dates. But beyond that, the difference between 4.9% and 5% in terms of impact is practically zero.

The real issue is what happens next. We can all count, and the next number after 5 is indeed 6. The big question for markets is whether we now journey towards 6% for the 10yr yield. We note here that, should we journey from 5% to 6%, it would not necessarily have to be catastrophic. That's not to suggest it would be market positive; absolutely not. And speed matters a lot. Shooting for 6% in the next month or so would likely be quite damaging. Something more gradual stretching over, say, six months, could be open to a less dramatic market reaction.

We're not calling for 6% per se. Just mulling it for now. There should also be some dampening of any such move, as long-term value players look to at least begin the process of averaging in. Maybe not for near-term positive mark-to-market, but to reflect the reality that tops in yields are tough to pinpoint. Also, this can all be tamed by cooling inflation (we call for that in 2027) and a subsequent build in the discount for a rate cut (we expect that in 2027). But for now, we're running a dangerous gauntlet, making the rest of 2026 potentially quite tough.

Nervous markets can trigger big moves

Wider markets are increasingly challenged to keep it all together. Equities are still holding up, but VIX as a risk gauge has clearly moved away from earlier lows. Also, implied rate volatility measures are showing a spike and reaching levels last seen in April.

Markets are clearly getting nervous, which means any setback can trigger material moves. So far, growth data has held up well, which has enabled a significant repricing of central bank reaction functions. Together with record-high equities, downside economic risks seem to have moved to the background. But with oil jumping higher every day and European gas trading well beyond previous highs, we see plenty of risks ahead.

Real rates have risen significantly since earlier this year, which offers a buffer for bondholders in a downturn. In theory, real rates could come down even if energy prices keep rising. So far, this has not been the case, however. Positive economic surprises and concerns about high issuance have helped real rates higher. But an economic downturn could quickly turn this narrative and pull rates lower alongside.

Tuesday’s events and market views

Oil still drives market dynamics, but data could become one factor determining the feed through to the long end as economic knock-on effects are eyed. Following the UK jobs data, the main focus in Europe will be Germany’s ZEW indicator. Here the consensus is looking for a less negative reading on the current situation and a more upbeat reading on the expectations component. European Central Bank speakers scheduled for Tuesday are Vujcic, Moulin, Escriva and Cipollone. Isabel Schnabel will rehash her slides from Monday at a dinner event with the SPD economic forum.

US data today is limited to the Empire manufacturing index and ADP weekly payrolls' data.

In primary markets, Germany will auction 2y bonds (€5bn) and Finland will auction 6y and 10y bonds (€1.5bn). In the broader Sovereign, Supranational, and Agency market, the EU will sell a new 3y and a new 30y benchmark via syndication. In the US, the Treasury will auction 20y bonds (US$13bn).