Markets are remarkably relaxed about US base rates potentially reaching 3%. This feels like an unstable equilibrium at times but market stress indicators are retreating. Implied volatility remains elevated but it seems investors are more reluctant to take interest rate risk than credit risk.
Market stress indicators retreat, making peace with higher yields
Markets continue to see the glass-half-full with a lot of market stress indicators showing signs of improvement over the past few days. This is not only an upbeat read on the risk of further escalation between Russia and the west over the Ukraine invasion, whether this is justified or not. The stabilization in many markets brings hope that they are coming to terms with the prospect of higher rates, even if this means the US short-end soon flirting with a 3% handle.
Stress indicators are retreating despite the prospect of policy tightening
Source: Refinitiv, ING
We have written before about the looming divergence between US and European monetary policies, and thus the need for rates to de-couple. Despite the obvious divergence in tone, rates have risen across the board, and have failed to spook investors. This confidence is remarkable, especially in light of the Fed’s stated objective to slow demand, and to take monetary policy into restrictive territory. European central banks have made no such promises, but this is the conclusion markets have reached, as exemplified by inverted forwards curves.
End-2023 USD forwards are closing in on 3% but the curve is more inverted
Source: Refinitiv, ING
Not all risks are equally scary
As long as this relatively sanguine market reaction persists, safe haven demand for government bonds should be limited. We have written in yesterday’s Spark that we doubt current valuations will do much to entice price-sensitive buyers. This is particularly true as long as swap spreads remain wider than their pre-war levels. Price insensitive buyers, more those concerned with the return of investment than return on investment, may well emerge, but at a later stage.
Yields and volatility usually move in tandem, and signal difficult trading conditions
Source: Refinitiv, ING
Some corners of rates markets do not display the same calm however. Implied swaption volatility logically signals that large market gyrations are expected to continue, with rates being dragged out of the sedate world of ‘lower for longer’. Expected returns and volatility usually move in tandem: the higher the risk, as measured by volatility, the higher the return required by investors, as measured by yields. The stabilization of spreads but sell-off in core bonds suggests that this logic applies more to interest rate risk than to credit risk.
Today’s events and market view
There will be no let up in central bank speeches today. From the Fed, Jerome Powell will probably be most closely followed after his hawkish intervention earlier this week. He is joined by Mary Daly and by James Bullard. The bar is high for the Fed to sound more hawkish than it already has this week, but these speeches could cement 50bp hike expectations at the June and May meetings, which are 85% priced already.
From the European Central Bank, Joachim Nagel and Ignazio Visco are scheduled. Bank of England governor Bailey completes the list. Their more measured tone may not stop a bond sell off on its own but at least euro bonds should hold better than their US counterparts.
Sterling markets will focus on the spring budget statement, with a focus on potential fiscal answers to the cost of living crisis, and associated borrowing needs.
On the economic release front, US housing starts and Eurozone consumer confidence are the highlights.
Italy has mandated banks for the syndicated sale of a 8Y floating rates note, and Austria for a 10Y benchmark. We suspect supply has played an instrumental role in this week’s bonds sell-off. If this is the case, slowing supply at the end of the week should help.
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