Rates Spark: The Overshoot Commences

A good series of PMIs has helped nudge global rates higher. It's taken us above some key levels, namely 5.1% on the US 10yr and 3.5% on the Euribor 10yr. And the move is likely far from over. To add insult to injury, we note that debt dynamics don't necessarily benefit from this.

PMIs have their day in the spotlight, and the US Treasury yield tops 5% with some conviction this time

The US composite PMI for September, at 58.4, is knocking on the door of 60. Above 60 has historically been associated with boom circumstances (at least on the ISM). Certainly, some areas of the US economy are quite boomie. The Tech sector, for starters. But corporate America too. But that's the antithesis to the Michigan consumer sentiment survey, which has suggested that things have never been as bad. So bad, the data are hard to believe. Two absolute extremes. The US 10yr took note of the PMI, and shot back above 5%, even breaching above 5.1%. And the carry spread (funds rate to 2yr) is back up at over 100bp. Plus, the probability of a rate hike in October has moved above 70%. It feels like Treasuries have decided that enough of this pondering below 5% for the 10yr yield – let's just shoot above as that's where we should be. We have no issue with the move.

As we noted here, it's not impossible that we get through the coming months without another significant move higher in long-end yields. However, the balance of probabilities suggests there is at least one more leg of long-end weakness still to play out. In an extreme scenario, this could take US 10-year yields into the 5.25% to 5.5% range. Specifically, we nudged higher anticipated end-year 10yr bond yield forecasts. It was a subtle move (was 4.9%), but significant in the sense that it brings into play some key levels. In the US, the key number for the 10yr is now 5.1% at year-end, while for the eurozone we’re in the 3.5% area for long-tenor rates. This is where we are now, but importantly, leaves open the risk that we're at the beginning of an overshoot process that has just begun. Now the overshoot risk really comes to the fore, and here we're still just 50bp ish above what we consider to be "normal yield levels".

Better growth is not necessarily good news for European government debt dynamics

A sound series of PMIs also pushed up euro rates, but this is a double-edged sword – higher rates can also translate to wider European government bond spreads. The spread between French 10Y government bonds (OATs) and German Bunds widened by some 6bp, pushing the spread to well above 100bp. The first stretch of the widening was driven by upside growth surprises in the eurozone, but the last 3bp was due to moves in US rates.

An improving global growth story should in theory support the fiscal outlooks of countries, but only if the improvement is proportional to the rise in rates. Compared to a year ago, the yield on a 10Y Bund is now around 100bp higher. From a debt sustainability perspective, nominal growth expectations should improve by at least 1% to match the repricing in rates. One could argue that markets were too pessimistic on long-term nominal growth expectations last year, but a full percentage point increase is a big increase.

The challenge here is that the rise in rates has been predominantly driven by external forces. US markets have taken the lead in pushing longer-dated real rates upwards, and Japan has also added to that pressure. Meanwhile, oil prices have pushed rates higher on the short end of the curve, but this has spillovers to longer rates too. All these factors can keep upward pressures on euro rates in the near term, even if the growth environment were to weaken.

Thursday’s events and market views

After French consumer and manufacturing confidence numbers in the morning, the focus will be on the German Ifo readings. After strong German PMIs, markets will likely look for more promising signs in the expectations component. From the US we have weekly jobless claims numbers and new home sales data.

Italy will auction 2y BTP, 5y BTPei and 11y BTPei for a total of €4.5bn. The US will auction a new 7y Note for a total of $44bn.