Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Fixed income market the week ahead
Althea Spinozzi
Head of Fixed Income Strategy
Summary: This week it's all about the nonfarm payrolls on Friday. Another jobs miss might reinforce doves' convictions that the Federal Reserve will need to hold its accommodative stance for longer. However, we believe that since the last FOMC meeting, the central bank's focus has shifted from jobs to inflation. Therefore, any element showing that the rise in prices will be persistent may weigh more heavily on monetary policies than lagging job markets going forward. That's why hawks will be looking at wages as salary increases might be a sign that inflation is not transitory. We expect 10-year US Treasury yields to trade rangebound between 1.5% and 1.7% until Jackson Hole. Still, in the last quarter of the year, we will see a bear-steepener led by tightening monetary policies. In Europe this week, we have heavy issuance of long-term bonds in France, Italy and Spain, which may provoke yields to resume their rise. Yet, another Bond issuance to finance the NextGenerationEU (NGEU) fund will slowly begin to contribute to spread compression across European sovereigns.
This week the market is going towards nonfarm payrolls completely changed.
For the first time since the beginning of the Covid pandemic, the Federal Reserve has placed more importance on inflationary pressures than jobs numbers. Indeed, the central bank has started to warn about a possible tapering despite jobs have missed expectations for two months in a row showing that inflation is becoming a bigger focal point. Indeed, the central bank can afford to hold its accommodative stance only if inflation is transitory. During his testimony for Congress last Tuesday, Powell admitted that the central bank found inflation to be larger and more persistent than expected, suggesting that transitory may be longer than expected. The stakes for the debate on the transitory nature of inflation are high. If inflation is not transitory, rising prices can undermine personal purchasing power and ultimately weigh on economic growth as well as jobs.
That’s why while the doves will focus on the nonfarm payrolls, the hawks will be focusing on wage data, which are estimated to gain 3.6% year-over-year, a record in twelve years. An increase in wages underpins long-term inflationary forces that increase the money supply of consumers. At the same time, it may increase product prices as businesses have to pay for higher salaries.
On the other hand, doves will focus on jobs data that have disappointed expectations. They will highlight that weak jobs mean that the Federal Reserve may need to be accommodative for longer, putting downward pressure on US Treasury yields.
The doves' problem is that if long-term US Treasury yields fall further from where they are, it makes an early start of tapering and interest rate hikes more likely rather than less.
Let’s assume a Fed’s tapering announcement in September. An actual first taper may follow as early as October, catching the market off guards. Depending on how severe inflation is, the central bank might push forward interest rate hikes, too. Right now, 2-year US Treasury yields quote around the upper range of the Fed’s Fund target rate at 0.25%. However, Eurodollar futures are pricing interest rates at 0.5% by December next year. The divergence between the two markets shows that the front part of the yield curve may soon move higher despite the massive liquidity that continues to exist in the money market space.
The short part of the yield curve is not the only one at risk. Recently, long-term yields have been falling on the assumption that inflation is transitory. The speculation on the long part of the yield curve is that an imminent tapering would force the central bank to return to its accommodative stance shortly after a period of tightening because inflation will stabilize or even lag. This scenario falls apart if there are signs that inflation might not be transitory since the Fed will be forced to tighten for a more extended period. Thus, long term US Treasuries remain exceptionally vulnerable and even though in the short term they may fall as inflationary signs are not clear, during the second part of the year, they are likely to resume their rise towards 2%. Depending on surprises concerning tapering talks and inflationary data, 10-year yields can break above this pivotal level, accelerating the increase of real yields.
During summer, we expect 10-year yields to trade rangebound within 1.5% and 1.7% until further tapering talks. However, suppose jobs data disappoint once again this week. In that case, there is potential to see yield breaking below 1.40% and find new support at 1.2%. Yet, the downward trend will not be supported in the long term. As we progress towards more signs of permanent inflation and acceleration of tapering talks, we will most likely see yields resuming their rise.
Recovery and inflationary pressures will not change the ECB accommodative stance
In Europe, the focus will be on the pace of the recovery and inflationary pressures. On Friday, Italy's national statistics institute ISTAT's manufacturing confidence index showed that morale is improving notably, with the index rising to 114.8 in June, the highest since 2000. The news led to a selloff in Italian government bonds, which intensified in the afternoon as the Italian Treasury announced the issuance of 10-year BTPS. Yields of 10-year BTPS closed 6bps higher on the day at 0.92%.
The pace of the recovery is a central theme for European sovereigns as yield will shift higher as the economy reopens. Yet, the European recovery is lagging other countries. Indeed, while economic growth in the United States and China is already at pre-pandemic levels, Europe will reach pre-pandemic growth by 2023-24. According to OECD data, Germany’s growth is estimated to meet pre-pandemic levels in six months, while France and Italy will need to wait another year. Thus, the ECB will need to continue to remain accommodative and stimulate the economy through its various quantitative easing programs keeping European sovereign yields in check until the German election. It’s important to note that the correlation between US Treasuries and European sovereigns remain positive. Therefore, if yields in the US resume their rise before fall, we can expect European bond yields to follow suit. However, the biggest change in the European bond market will come with the German elections. Indeed, more fiscal spending and better European integration will most likely be the new government's top priorities.
Therefore, even though we might see BTPS leading losses in the short-term, the BTPS-Bund spread is likely to tighten in the long term. The spread compression trend among European sovereigns has already set in motion as Europe issues joint liability bonds to raise money for the NextGenerationEU fund. On the 15th of June, Europe raised €20 billion with a 10-year debut bond at 0% in yield. Order books exceeded €140 billion, roughly seven times the amount sold. This week, the market is waiting for the announcement of another European bond issuance.
We even may see Spain and Serbia issue green bonds for the first time, providing a much-needed supply to a fast-growing market. We expect the Green bond space to grow as governments will find it convenient to issue these securities at a lower yield than their benchmark as the "greenium" currently ranges from -2bps to -6bps. Moreover, green projects tend to have a longer time horizon making them excellent social long-term investments, contributing to spread compression across the European Union.
We will look at these topics in our Quarterly Outlook, which will be launched this week and invite you to attend the launching webinar by clicking here.
Economic calendar
Monday, the 28th of June
- United States: Dallas Fed Manufacturing Business Index, 3- and 6-Month Bill Auction
- Japan: Unemployment Rate, Retail Trade
Tuesday, the 29th of June
- France: Consumer Confidence, ILO Unemployment
- Spain: Retail Sales, Consumer Price Index
- United Kingdom: Consumer Credit, M4 Money Supply, Mortgage Approvals
- Eurozone: Service Sentiment, Consumer Confidence, Industrial Confidence, Business Climate
- Germany: Consumer Price Index
- United States: Redbook Index, Housing Price Index, Consumer Confidence, S&P/Case-Shiller Home Price Indices, Consumer Confidence
Wednesday, the 30th of June
- Australia: RBA’s Governor Lowe Speech
- Japan: Industrial Production, Private Sector Credit, Construction Orders, Housing Starts, Consumer Confidence Index
- China: Non-Manufacturing PMI
- United Kingdom: Total Business Investment, Gross Domestic Product, Total Business Investment
- France: Producer Prices, Consumer Price Index
- Switzerland: KOF Leading Indicator, ZEW Survey - Expectations
- Germany: Unemployment rate
- Spain: Current Account Balance
- Italy: Consumer Price Index, 5- and 10-year BTPS
- Eurozone: Consumer Price Index
- United States: MBA mortgages applications, ADP Employment Change, Chicago Purchasing Manager Index, Pending Home Sales
- Canada: Raw Material Price Index, Industrial Product Price, Gross Domestic Product
Thursday, the 1st of July:
- Australia: Building Permits, Commonwealth Bank Manufacturing PMI
- Japan: Tankan Large Manufacturing Index and Outlook, Tankan Large All Industry Capex
- New Zealand: Trade Balance
- China: Caixin Manufacturing Index
- Japan: 10-year Bond Auction
- Switzerland: Real Retail Sales, Consumer Price Index
- Spain: Markit Manufacturing PMI, 5-, 7- and 30-year Obligaciones Auction
- Italy: Markit Manufacturing PMI
- France: Markit Manufacturing PMI, 10- and 20-year Bond Auction
- Germany: Markit Manufacturing PMI
- Eurozone: Markit Manufacturing PMI
- United Kingdom: Markit Manufacturing PMI
- Canada: Markit Manufacturing PMI
- United States: ISM Manufacturing PMI and Employment Index
Friday, the 2nd of July:
- Germany: Retail Sales
- Eurozone: Produce Price Index
- United States: Nonfarm payrolls, Average Hourly Earnings, Goods and Services Trade Balance, Labour Force Participation Rate, U6 Underemployment Rate, Unemployment rate, Factory orders
- Canada: Trade Balance
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