Rates Spark: Sticky Circumstances

US long rates set to remain sticky to the upside, as a material downside impulse is far from straightforward. Rates volatility in euro rates is still coming down despite strong daily swings. Possible future rate paths seemed to have narrowed with oil likely stuck around elevated levels. Inflation data later this year could revive significant volatility.

US 10yr Treasury yield trending in the 4.45% area

The relevance of the shuttering of the Strait for US bonds is not easy to discern from absolute levels of yields. The 10yr inflation expectation at comfortably under 2.5% is actually quite a benign reading. Even a dramatic reopening of the Strait should not cause a material collapse lower. And the 10yr real yield, at around 2%, is not particularly elevated either. It looks elevated relative to the paths seen in the past couple of decades, but that is a period heavily biased by GFC/pandemic induced ultra-low real rates, in tandem with Fed bond buying and the fund rate in the area of zero. Indeed, the 10yr real yield dipped deep into negative territory for extended periods. That's not the norm.

The norm is more in tune with where we currently are, consistent with a normal 2% GDP growth tendency. In fact, during the dot.com boom, the 10yr real yield was up at 4%. The rationale for maintenance of a high real yield currently centres on higher productivity driven growth ahead stemming from the ongoing tech boom. And let's throw in there the elevated fiscal deficit too; another circumstance that can correlate with elevated real yields.

Real yields can fall ahead, but for that to occur, we'd likely need to see a recessionary tendency. While some macro data point to this risk, that's typically in the "traditional macro economy". Absolutely important, of course, but it's the tech-driven economy that has taken on the mantle of future growth. We think that gets reflected in sticky 10yr yields at elevated levels, while the front end is likely to be more responsive to the traditional day-to-day macro numbers.

Euro rates volatility coming down for now but don't discount inflation surprises later this year

Despite the sharp moves in rates on a daily basis, implied volatilities for euro rates suggest the uncertainty going forward has already come down significantly. In effect, the range of possible future rate paths has narrowed. Scenarios whereby Brent oil either surges above $150 per barrel or falls back below $80 seem increasingly remote. One can also see this in the 10Y euro swap rate, which for the past few months has mostly oscillated between 3.0% and 3.1%, a relatively narrow range of just 10bp. And we tend to agree with these market dynamics. With oil likely to remain stuck at elevated prices, the long end of the curve could continue to trade sideways for a long time.

Rates volatility can remain subdued for now, but this is likely to change later this year once potential second-round effects find their way into inflation numbers. If eurozone core inflation remains anchored close to 2%, the European Central Bank will be in a much better position to keep policy rates stable. But any signs of inflation unanchoring could force more hikes than the current 70bp priced in. Inflation data will therefore become increasingly important, although this week’s eurozone CPI won't do much. Some country data have already been released and elicited only muted market reaction. And indeed, one month's print is also not going to change the bigger picture where fears of second-round effects take time to materialise.

Tuesday's event and market view

The eurozone will see the release of the flash CPI for May, where the core rate is expected to rise to 2.4% year-on-year while the headline is seen accelerating to 3.2% on the back of energy prices. The inflation figures will frame the public appearances of ECB speakers ahead of the blackout period starting Thursday. Slated to speak on Tuesday are the ECB’s Rehn, Vujcic and Sleijpen.

In the US the JOLTS data will be parsed for any growing weaknesses in the labour market ahead of the official jobs data on Friday. Fed speakers for the day are Kashkari and Hammack.

In primary markets, Germany will auction €5bn in 2y bonds. The UK auctions £3.25bn in 11y green gilts.