Rates Spark: US 10yr Continues To Target 5.25%+

The overshoot to the 5.25%-5.5% area for the US 10yr yield is ongoing. The front end paused after valuations looked stretched, but resilient macro data, elevated energy prices and inflation pressures generally continue to pressure yields higher.

The rate hike discount looks extreme, but long bond yields can remain under pressure

The US 7yr auction tailed moderately. Not as horrendous as the previous day's 5yr auction, which tailed by a substantial 3bp. That auction was the last straw on Wednesday, prompting a follow-through rise in the 10yr yield to over 5.1%. Fast-forward to Thursday, and we're suddenly knocking on the door of 5.2%. And the driver? Predominantly it's higher real yields, as it has been for a number of months now. Which is important, as this is not shielded by the Fed hiking rates, which could be the case if we had an inflation expectations issue. We have a printed inflation problem in the rear-view mirror, but inflation expectations in fact remain relatively contained.

Ahead, we think that there are enough rate hike fears discounted at this juncture, and certainly enough to take care of perceived inflation risks. But, government bond yields are primed to remain under pressure on a pure debt dynamic theory, which translates into pressure for some re-widening in swap spreads, and especially in the 10yr area. So far, Treasury Secretary Bessent's buyback programme has in fact been successful in the sense that it was followed up by tighter swap spreads.

Thursday saw US$4.1bn bought back in the latest reverse auction, but we're not of the opinion that the market should be overly concerned with this, in the sense that it's not a negative. It’s still a moderate positive for the long end, as the Treasury is doing at least double what they did. We get there is disappointment that it has not been more. But that was never intimated by the Treasury Secretary in the first place, in our opinion. The Treasury Secretary, in fact, should be pleased that swap spreads remain relatively contained, so far at least.

The bearish narrative remains intact with none of the key drivers behind the recent sell-off is showing signs of fading

None of the drivers that brought us the increase in rates are going away. The front end has taken a small breather after valuations started to look stretched, even as oil continued to climb. For the European Central Bank, a full 100bp priced in over the next year does appear ambitious, given that there is still a lot of uncertainty around the outlook. But ECB chief economist Lane basically confirmed on Thursday that the ECB sees itself confronted with the adverse energy market scenario while, at the same time, all data points to ongoing macro resilience.

Long-end rates remain more exposed to upward pressures, with the Bund probing towards 3.6%. That also means limited relief for spreads, with 10y French OATs still yielding 109bp above Bunds. Keep in mind that the ‘positives’ for France from better data are also limited, with the latest business climate indicator falling. Indeed, the overall strong PMIs masked an unexpected decline in the French manufacturing index. Regarding the broader sentiment, the weakness in equities seems more a mechanical reaction to the rise in rates rather than a genuine risk-off move at this stage. The VIX equity fear gauge stands close to the low end of this year’s range.

However, after Wednesday's level-shift higher in rates, the next big moves are more likely to come next week as it features several important data releases. The underlying tenor should not stand in the way of the bearish sentiment.

In the eurozone, the flash CPI releases start on Tuesday with reports from Spain, followed by France, Germany and Italy on Wednesday, and will be scanned for confirmation of the expected rise in both headline and core inflation rates before the eurozone-wide estimate.

It is also a big week ahead for US data, with the official jobs market data for September at the end of the week. At the time of writing, the consensus is pencilled in at a solid 104k increase in non-farm payrolls. The PCE data for August will only confirm the elevated price pressures, as the inputs are largely known from other releases. We will also get the ISMs, which in the US are usually more closely watched than the S&P PMIs, but the market will be looking for confirmation there too.

Friday's events and market view

In terms of eurozone data we will be looking at the German consumer confidence data and the ECB M3 data. The US will release durable goods orders for August and the final September reading of the University of Michigan consumer confidence index. It will be busier on the central bank speaker front. The Fed's Williams, Schmid and Hammack are scheduled for the day. The Bank of England's Bailey will also speak. From the ECB we have Vujcic.

After the markets close, the scheduled reviews from Moody's will be in focus: Italy (Baa2/Stable, the ESM and the EU (both Aaa/Stable) are on the agency's list for the day. S&P has Slovenia scheduled for a possible review (AA/Stable).