Rates Spark: Hikes Coming, But Bond Yields Choosing To Fall

US Treasuries are in a mood to test the downside for yields after all. Still not sold on following through on it. But monitoring. The ECB meeting did not change our rates outlook and confirms a December hike is likely. We brace for more volatility as Friday's CPI and GDP readings from the eurozone are important ingredients in markets' rate hike expectations

US Treasuries looking through the rate hike narrative for December

The US 10yr yield made a decisive gap away from 5%, but to the downside. This was not a fundamentally driven move, in the sense that Thursday's PCE inflation data continued to point to an ongoing significant deviation from where Chair Warsh would like to see it at (he reiterated in the aftermath of the FOMC meeting that he wants to see 2% on core, but it rose to 3.1% for September). The income, spending and jobless claims data were also in line, and at the firm end of the range.

Instead, Treasuries are willing to remain quite responsive to the vagaries of the sentiment on AI valuations and equity market wobbles. Nothing terribly sinister went down here, but the ongoing mood music has just turned that bit sour. Meanwhile, the 7yr auction was fine, with no tail, and met decent demand.

What we can say is the move was more a back-end thing than a front-end one. Some chunky flows did go through on the buy side. We can't ignore this move, as it's contrary to our preferred morph back in the direction of higher yields. But there is not enough in it to cause us to change our tune.

ECB close to a next hike

Although debating it, the European Central Bank (ECB) refrained from a rate hike on Thursday. The tightening of financial conditions amid rising bond market yields tipped the balance, as they have done the work for the ECB.

The signal that a December hike was in the offing was pretty clear. Unless we get any positive developments in the Middle East, or adverse developments in French bond markets, December looks like a done deal. And markets have been treating it that way already, with more than 20bp of tightening discounted.

The market takeaway from Thursday's events was still a less hawkish one. A Reuters report about ECB staff estimating that higher bond yields could cut cumulative growth by 100bp and inflation by 90bp in 2027-2028 relative to the September projection adds to the notion that the December hike could be the ECB’s last of the cycle.

While this is also our baseline scenario, more needs to fall into place for markets to lean more in that direction. Easing energy prices and no evidence of second-round effects would certainly help, but especially on the latter, greater certainty needs to be established over months of tracking the data.

Currently, the market still sees the upside inflation risks flagged by President Christine Lagarde as keeping the ECB on a hawkish footing. While the market’s pricing for further ECB tightening over the next 12 months has dropped towards 65bp, this was mainly driven by French-related risk-off momentum and, of late, also growing AI jitters. As arguments for the ECB to change its tack, the spread widening thus far will likely not be sufficient, meaning the market will remain exposed to bearish risks.

Friday’s events and market views

A data-intense day for the eurozone, including CPI numbers from France, Spain and Germany. In addition, we also have eurozone GDP estimates for the third quarter. Rates have been pushed higher by second-round inflation fears and still robust growth, so all these releases will feed directly into the euro curve. Also watch for comments from ECB speakers reflecting on Thursday's meeting and reacting to the many data points.