Rates Strategy: Low And Slow

Gravity is reasserting itself in interest rates. Low rates and low volatility benefit positive carry trades, such as sovereign spread tighteners and long-end steepers. The Fed's balance sheet continues to ease lower, illustrating reduced systemic stress. Rates are thus more reflective of macro angst. Fed corporate buying also remains quite tame.

Source: Bloomberg, ING

Low and slow…

When we said yesterday that we expected rates to return to their COVID-induced downtrend, we didn’t think they would be able to shrug off a strong jobs report. As our economics team noted, the headline number doesn’t tell the whole story and the prospects for the July report are grim, as more contemporaneous indicators suggest. Still, there is optimism in financial markets, equities notably have been defying gravity of late, largely ignoring ominous signs that the epidemic is taking its toll on economic activity. If sentiment indicators continue to surprise to the upside across the world, the latest instance being the beat in Caixin China PMIs released overnight, the record number of COVID cases in the US should give investors pause for thought.

Today’s session promises to be less eventful with US markets closed and only second PMI readings on the data docket. Our base case is that interest rates continue their plunge, towards -0.50% for 10Y Bund as a short term target. Another view of ours is playing out at the same time: peripheral bond yields continue to converge to their core peers. As we wrote after the June ECB meeting, the pace of tightening is slower now but our conviction that 10Y Italy-Germany will go through 150bp is greater. Yesterday evening, the Bundestag voted that the ECB's PSPP satisfied the German Constitutional Court's proportionality requirement, in line with earlier press reports.

… good for spreads and long-end steepeners

Another side effect of the normalization in interest rates markets, as we consider low rates and low volatility to be their equilibrium under heavy monetary accommodation, has been a re-steepening of the long-end of the curve. As for peripheral spreads, the re-steepening is slow but our conviction is increasing, and as for peripheral spreads, investors have time on their side. Both spread tighteners and long-end curve steepeners are positive carry plays, the very reason why they benefit from lower volatility and easy monetary policy.

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