With souring risk sentiment and already high expectations of ECB easing, we struggle to see what could prevent further sovereign spreads widening. Rates markets gloom has been concentrated in EUR so far, keeping the spread to USD wide. That suggests that this lower rates narrative has been made in Europe, although weak US jobs threaten this state of play.
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Overnight: Brexit deadline #1..of many
On the day of the self-imposed October 16th deadline, the Financial Times reports British PM Johnson will attempt to force 'a moment of crisis' in a speech today. According to the newspaper the PM is unlikely to walk away from talks but may brandish the threat. Markets remained calm overnight reflecting, in our view, the belief that further rounds of talks will ensue.
US spread to Germany stretches wider
US market rates have resisted the pressure to move significantly lower in the past few days. Most of this pressure has come from the worsening European Covid narrative, which has correlated with another lurch lower in Eurozone market rates. The spread between US 10yr rates and German ones is at its highest since the crisis caused that spread to collapse; which tells a clear story - the US medium-term recovery story is holding up better than the Eurozone one.
The US versus Eurozone 10yr yield spread is now back up above 130bp, having been as low as 100bp. This is still some way from the 200bp-plus spread that is more typical, but it is at least is a step in the right direction. The only anomaly here is that typically that spread is widening when market rates are rising (led by higher US rates). Here, market rates are falling. Should falling rates continue, it will likely bring the US-Eurozone spread back down again; a more typical outcome from a falling rates backdrop.
Today’s US releases will bring more hard data on the health of the economy. The narrative so far in this crisis has been the US economy strongly outperforming its European peers. In this context, it is not surprising to see the 10Y swap rates differential between the currencies having almost reached our 105bp forecast formulated last week. This narrative may be challenged in the coming weeks as the job market gives signs of losing momentum, and if markets come around to the view that fresh European lockdowns are just a few weeks ahead of the US.
Peripheral debt, more underperformance pending ECB reassurances
As risk sentiment deteriorates in global markets it is worth noting a reversal of certain dynamics that were prevailing in rates since the summer. In EUR, our view that sovereign spreads tightening on rates rallies was unsustainable proved correct. The tightening streak of Italian bond yields versus Bunds saw a setback yesterday with the 10Y spread widening by c.7bp to over 130bn again. While the situation is likely to remain more unstable as coronavirus fears rear their head again, against a backdrop of spreads having traded over 250bp in May, the latest move looks less worrying, though. We continue to subscribe to the theme of convergence between peripheral and core debt markets but we only expect it to resume close to the announcement of further ECB easing, likely not before December.
As our economics team pointed out, the impact of a second covid wave on Italian public finances will be greatly eased by the joint support of the ECB, the EU, and perhaps the ESM, over the coming years. This should prevent a build-up in sovereign and systemic risk that characterized bond markets at the peak of the first wave back in March. With a shorter timeframe in mind, we expect the ECB would have to give strong reassurance to the market at its October 29th meeting to prevent further widening, however. Indeed, expectations regarding support from the EU and the ECB are already running high. Any adverse impact on the government finances of renewed virus containment measures could be amplified by potential delays in EU recovery fund payouts.
Today's events: US data and day two of the European Council
In data today's focus squarely lies on the US with releases of retail sales, industral production, and the U.of Michigan consumer sentiment indicator. Or economists expect all three to still post decent increases. With the labor market improvements stalling and income support from government benefits waning the numbers may soften more as we head towards year-end.
Europe sees the second day of the EU Council meeting. After kicking the can further down the road on Brexit the attention should turn to the worsening situation surrounding the virus.
In terms of bond supply, Belgium will hold a reverse inquiry auction, selling up to €0.5bn of 6Y and 50Y bonds.
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