Rates Spark: Inflation Obsession

Image source: Pixabay

The market’s obsession with the inflation tree means it risks missing the macroeconomic forest. Eurozone CPI this week should add to the bond market’s worries but our confidence in higher yields is stronger for the front end than for the back end.

Geopolitical optimism compounds the market’s hawkish bias

Inflation fear and geopolitical optimism are proving a toxic mix for bonds, especially European ones. The amount of hikes discounted by the euro swap curve strongly implies that the European Central Bank would look through the hit to growth caused by the war in Ukraine, and focus instead on the risk of inflation escaping its control. One could take issues with this reading, especially since the tone of ECB speakers has actually been a lot more cautious than what market pricing implies. Public intervention from the likes of ECB President Christine Lagarde today could cool down hike expectations, at least temporarily.

Lagarde today could cool down hike expectations

Hopes of de-escalation, if warranted, will only comfort markets in their hawkish view, however. At some point yesterday, the curve implied the deposit rate would peak somewhere around 1.25% within two years. That’s 175bp more than currently. Cooler heads would probably point out that the Eurozone economy is not out of the woods yet. Even if pricing out a degree of risk premia in safe havens, such as government bonds, is warranted, the hit to growth from higher energy prices could still be significant. The ultimate impact on confidence isn’t yet known, as the drop in Eurozone consumer confidence last week illustrated.

Consumer confidence is a warning that markets shouldn't focus solely on headline inflation

Image Source: Eurostat, ING 

We’re more confident in higher front-end than long-end yields

But market moves occur on timescales incompatible with taking all macroeconomic information into account, and recent ECB attempts to talk rates down have failed to move rates durably. There is a strong impulse coming from the US, and the Fed’s hawkish tone in particular. That is unlikely to ease barring a sharp slowdown in growth or inflation. The path of least resistance is thus for the rise in rates to continue in our view, even if our degree of confidence in US yields converging to 3% is greater for shorter than longer maturities.

Another upside inflation surprise should accelerate the EUR curve’s bear-flattening

Eurozone inflation numbers, pouring in between today and Friday, are also likely to fan the flames of the bond sell-off. We said before that the market’s obsession with spot inflation, at the expense of the growth picture and of long-term inflation expectations, is misguided. This is how we think markets should trade, however, not how they actually trade. Another upside inflation surprise should accelerate the EUR curve’s bear-flattening. Last minute index extension flow should also add to the flattening.

Today’s events and market view

As optimism surrounding Ukraine-Russian peace talks remain the main driver of rates globally, and especially in Europe, today brings an update on the inflation front. March CPI readings from Spain and Germany will provide a good indication of the Eurozone-wide print due on Friday. Even before the latest batch of upbeat headlines, markets were inclined to give more weight to the spike in inflation than to the hit to growth it might bring. The latest developments, if confirmed, are likely to magnify markets’ sensitivity to higher inflation.

ECB speakers have so far adopted a much more cautious tone than what is implied by yield curves. The same caution might be on display from the likes of Christine Lagarde, Peter Kazimir, Robert Holzmann, Pierre Wunsch, Gabriel Makhlouf, and Fabio Panetta.

Italy will auction 5Y and 10Y bonds.

In the US session, the main release will be ADP employment, as well as the third release of 4Q US GDP. From the Fed, Thomas Barkin and Esther George are scheduled to speak.