Rates Spark: An Unstoppable Force Meets An Unmovable Object

What happens when the unstoppable force of the European recovery collides with the seemly unmoveable rates market. The ECB can attempt to maintain the current equilibrium but this will result in more demand being displaced to high yielding alternatives.

EUR rates, the unmovable object

The performance in EUR rates so far this week has been rock-solid, and this allows markets to look to the few days separating us from the 10 June ECB meeting with relative calm. Positioning is difficult to assess given the market volatility and drop in yields since their mid-May peak. Our hunch is that longs/receivers have dominated price action in the past two weeks and are thus more liable to take risk off the table before the meeting.

We tend to still favour higher interest rates

Against this theory, one might disagree that interest rate and bond markets have largely shrugged off better economic data and heavy supply this week. The logical conclusion would be that today’s duration-heavy French auction and PMI services, if they meet already high expectations, would fail to make a dent in the strength in EUR rates. This is entirely possible but since this short-term conclusion clashes with our higher-conviction medium-term view, we tend to still favour higher interest rates.

ECB bond purchases smother rate volatility, a boon for financial markets, and the economy


The European recovery, the unstoppable force

To be sure, the proximity of the ECB meeting, and an apparent refusal to contemplate tapering, has helped EUR rates regain their poise of late. We think this hides an unstable equilibrium: one where ECB purchases smother rates volatility but where end investors balk at buying bonds that clearly yield less than what the recovery warrants, see for example the decrease in demand at German auctions. The way out of this conundrum is simple in our view, more and more bond demand will be diverted towards higher yielding alternatives as they offer at least a spread buffer against future rate rises.

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Disclaimer: This publication has been prepared by the Economic and Financial Analysis Division of ING Bank N.V. (“ING”) solely for information purposes without regard to any ...

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