Head of Fixed Income Strategy
Summary: This week's FOMC meeting will be an important focus for all assets. Although we expect the central bank to keep monetary policy unchanged, a rise in dot plot projections may signal hawkishness. It could provoke a fast surge of 10-year US Treasury yields back above 1.50%. Yet, there is potential for yields to break below 1.40% and find support at 1.20% before they resume their rise if the Federal Reserve keeps dovish. In Europe, the focus will be on Wednesday's 10-year German Bunds auction as they have recently been suffering from weak demand. A drop in appetite in Bunds may indicate that rotation from European sovereigns to the US peers has started, putting at risk German, French, Spanish and Portuguese government bonds. Finally, in England, the focus will be on possible extension lockdown measures, adding pressure to Gilt yields.
We are not surprised by last week's drop in yields for two reasons: the amount of liquidity in the market remains high, and rotation from lower-yielding sovereigns is compelling. These forces put pressure on both the front and the long part of the yield curve. Besides, they have hindered yields from rising amid high CPI numbers, causing investors to unwind short Treasuries positions. Unless there is a sudden change in the central bank’s message, we expect these factors to continue to weigh on yields until Jackson hole, where we anticipate the Federal Reserve to begin engaging with tapering discussion.
It doesn't mean that there isn't a risk for a surprise this week. So far, Jerome Powell has stuck to the Average Inflation Target (AIT) framework and reinforced the idea that inflationary pressures are temporary. Consequently, the bond market has accepted that interest rates will be lower for longer. However, the dot plot might be telling a different story this week if projections move higher for 2023. If that were the case, the transitory nature of inflation might start to become less credible, and yields may resume their rise.
Tomorrow the US Treasury is going to issue 20-year Bonds. In recent auctions, we have seen bidding metrics improving considerably for US Treasuries. For example, foreign investors’ demand for last week’s 10-year bonds was close to the highest seen since January 2020. Also, indirect bidders' demand was above the 5-year average at the 30-year auction on Thursday, despite the highest CPI reading since the global financial crisis in 2008. The reason for an increase in foreign demand might lie within falling USD hedging costs. It gives an advantage to investors to sell government bonds in their countries and lock in a higher yield in US Treasuries. Currently, EUR hedged 10-year US Treasuries pay a yield of 0.75%, a much higher yield than many government bonds in Europe.
In the case of a dovish Federal Reserve meeting, we might see 10-year US Treasury yields trying their support at 1.40%. If they break this level, they will find support at 1.20% next.
Suppose the dot plot projections show that members are increasingly more hawkish. In that case, we could see yields rising back above 1.5% to find resistance at 1.60%.
However, in the long-term, yields will need to rise. The transitory nature of inflation is subjective, and it depends on the way you look at it. The current spike will be short-lived, and we can expect inflation to normalize by the end of this year or by the beginning of 2022. Yet, the question is at what level it will normalize. Indeed, suppose inflation keeps supported at a much higher level than what we are accustomed to. In that case, the central bank will not have any other choice than to taper and hike interest rates. That’s why it’s crucial to reduce noise and to focus on data that signal whether inflation might keep supported for an extended period. The rise in wages and primary home rentals are pointing to something lasting, even if a great part of the current surge in prices is transitory. The latest CPI numbers show that food away from home has risen, making us wonder whether it is a way for restaurant owners to pay higher wages. We will know more about the transitory nature of inflation in the third quarter of the year. However, for long-term bond investors, it’s key to recognize that there is more downside in holding US Treasuries than upside. Indeed, if 10-year yields drop to 1%, it would represent a capital gain of roughly 4%. Yet, if yields rise to 2.5%, the loss on capital would be 9%, and it could be greater depending on at what level inflation will stabilize.
In Europe, the focus will be on the United Kingdom and whether the country will need to extend its lockdown measures in light of rising Covid-19 related cases. The country's vaccination program is well advanced, yet new strains are causing a rise in hospitalization. It could hamper the speed of an economic rebound forecasted by the Bank of England since the beginning of the year.
Last week, 10-year Gilt yields broke below the ascending trading range they have been trading since February, driven by the drop in yields in the US. This morning they are testing their 100 days simple moving average at 0.70%, and if they break below this level, they will find support at 0.65% next. The Debt Management Office will sell 7- and 30- year Gilts tomorrow and 15-year Gilts on Wednesday. Demand at these auctions might give an insight into investors' expectations on the recovery.
News of an extension of a lockdown in the UK could weigh on European sovereigns, too. However, our focus will be on rotation. Recent German Bund auctions showed demand is lacking for these sovereigns. One of the reason might be that we start to see a rotation from European sovereigns to the US safe-heaven. This week the German Finance Agency is issuing 10-year Bunds. Suppose demand in Bund is lagging, but demand is solid at tomorrow’s 20-year US Treasury auction. In that case, it may indicate that investors have started to rotate from lower-yielding European government bonds to US peers.
At the latest 10-year Bund auction, we have seen the bid-to-cover ratio dropping to 1.28x, the lowest since March last year. The lowest accepted bid was 100.9, the lowest since February 2019, showing that for appetite for these securities continues to fall. Rotation will pose a threat not only to Bunds but also to other lower-yielding sovereigns such as France, Spain and Portugal. Italian BTPS will be able to weather losses better as they are currently offering the highest yield in the bloc.
Monday, the 14th of June
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Wednesday, the 16th of June
Thursday, the 17th of June
Friday, the 18th of June
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Chief Investment Strategist
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Head of Fixed Income Strategy
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