Head of Fixed Income Strategy
Summary: Although the market is focusing on the rise of nominal US Treasury yields, we believe that the recent increase in US real rates is more alarming, and it is pointing to the fact that inflation expectations linger while the cost of capital is rising. This week, it will be critical to understanding whether inflationary forces will increase with nominal yields, pushing real yields lower and reestablishing the reflation trade. Thus, the Personal Consumer Expenditure data on Friday and developments on the Fiscal stimulus package will be in the spotlight. On the back of US Treasury yields rising, European sovereign yields are rising too. Lagarde's speech this afternoon will therefore be crucial to understand whether the European Central Banks is comfortable with rising yields or might need to ease the economy further in order to slow down this trens. In the meantime, violent protest in Spain might lead to the Catalan independence movement's resurgence, provoking investors to reassess their risk in the periphery.
This week the rise in US Treasury yields will continue to be in focus. This morning 10-year Treasury yields hit one year high at 1.39% as Australian bonds were falling and commodity and crude prices were rising. Ten-year yields continue to trade in the middle of the 1.2% - 1.5% fast area, which was produced last February as yields were quickly dropping in light of the Covid pandemic.
In only one month, 10-year Treasury yields rose more than 30 basis points, the highest since the 2016 US election. At the same time, we are witnessing a divergence between bond and stock market volatility, pointing out that a selloff in equities might be lagging. As yields continue to rise, more pressure will be applied on risky assets building up for even a more substantial selloff.
A rise in US real yields poses a threat to risky assets
We believe there are conditions for yields to rise fast towards the 1.5% level, where they will find strong resistance. Tomorrow, Powell will deliver the semi-annual monetary policy report to the Senate Banking Committee, and it is crucial to understand whether the Federal Reserve is going to let yields rise despite inflation expectations linger. Indeed something alarming is happening: while Treasury yields are rising, real rates are rising with them. It means we might be facing an unexpected rise in capital cost rather than rising inflation, posing an even more significant threat to risky assets.
Therefore, it becomes crucial to understand whether inflation pressures are growing, which is a question that may be answered on Friday with the release of the Personal Consumption Expenditures (PCE). The Federal Reserve prefers the PCE over the Consumer Price Index (CPI) because it measures the change in the price of goods and services consumed by all households. The CPI focuses on the change in the out of pocket expenditures from households. Economists are forecasting it to be around 1.4%, while it recorded 1.5% in December.
Although we don’t expect the 7-year note auction on Thursday to be particularly telling of market sentiment, it may give some clues on investors’ Treasury appetite amid rising yields.
Will the European Central Bank let European sovereign yields rise?
Across the Atlantic, a key focus is whether the rise in US Treasury yields will continue to provoke a selloff in European sovereign bonds. Since the beginning of February, European sovereign yields moved up by more than 20 basis points. As they continue to rise together with US yields, they will become a headache for the European Central Bank. Although European sovereigns continue to trade at historic low yield levels, if they rise too fast, they might tighten the bloc's economic conditions. Therefore, the ECB might need to intervene again to ease the economy reverting this trend. Lagarde's speech this afternoon is crucial in understanding how the ECB views the rise in yields and whether more monetary stimulus might be expected.
The Ifo Business Climates and Expectations data released today and the GfK consumer confidence data released on Thursday will also dictate sentiment in European sovereigns. The question is whether the bloc's biggest economy is entering into a recovery despite being in a second lockdown since December. Last year, Germany's GDP contracted by 5%, a record since the Second War World.
Troubles in paradise for the periphery?
A potential anti-establishment threat in the periphery seemed to have been put at rest since Mario Draghi entered Italian politics. However, in the past few days, we have seen some troubling events happening in Spain. We believe that in Barcelona, violent protests against the rapper Pablo Hasel's incarceration might lead to a resurgence of the Catalan independence movement. Although at the core of the protest, there is a debate over free speech in Spain, the fact that issues occur in Catalonia, a region that has seen to obtain independence from Madrid, gives an opportunity to "idependistas" to advance their agenda. If that was the case, we might see investors starting to reassess risk in the periphery, starting from Spanish Bonos but leaking to the periphery as a whole. It is key to monitor the Bonos-Bund spread in this environment as any unexpected widening might leak to Portuguese and Greeks Bonds. In this scenario, Italy will remain resilient thanks to the honeymoon provoked by Mario Draghi's entrance into Italian politics.
Economic Calendar
Monday, the 22nd of February
Tuesday, the 23rd of February
Wednesday, the 24th of February
Thursday, the 25th of February
Friday, the 24th of February
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