Head of Fixed Income Strategy
Summary: Wednesday's FOMC meeting is going to dominate market sentiment. The focus will be on inflation and whether it could force the Federal Reserve's hand into hiking interest rates earlier than expected. Investors should be cautious in their bets: short interest on the iShares 20+ Year Treasury Bond ETF (TLT) hit a new record high. Any surprise at the FOMC meeting could cause a short squeeze provoking a sudden drop in long term US Treasury yields. The Bank of England is also in the spotlight as it may deliver its first interest rate hike since the Covid pandemic. Yet, the recent flattening of the long part of the Gilt yield curve shows that an aggressive interest rate hike cycle might be short-lived.
This week’s FOMC meeting is going to dominate market sentiment. Investors are expecting the Federal Reserve to begin tapering as early as mid-November. However, the focus will be on the timing of interest rate hikes as the inflation threat continues to grow.
The bond market is betting for the beginning of an aggressive interest rate hike cycle already by the end of tapering in the second half of 2022. The spread between 30-year and 5-year US Treasuries (5s30s) is well below 100bps and only 4bps above the spread between 5-year and 2-year US Treasuries (2s5s). The convergence between the two signals the beginning of an imminent rate hike cycle despite the Fed is not hinting at it yet. Bond investors are therefore walking on a fine line ahead of Wednesday's FOMC meeting. There is either the possibility that early interest rate hikes expectations are mispriced or that the central bank will be forced to engage in early interest rate hikes due to high inflation.
The continuous tightening of the 5s30s spread is also striking. As we mentioned in previous pieces, long-term yields might fall amid assumptions of a policy mistake. Yet, it's unlikely that they will continue to fall amid earlier interest rate hikes expectations.
However, we cannot ignore that short positions in TLT (iShares 20+ Year Treasury Bond ETF) are record high. Therefore, a surprise at this week’s FOMC meeting might provoke a short squeeze that could force long-term rates lower in the short-term.
Ultimately, we believe that inflation will force the Fed’s hand into considering to end tapering aggressively and begin with an interest rate hike cycle as early as July 2022. Within this context, the only direction for yields is to soar throughout the next year.
Inflation might finally force the hand of the Bank of England this week to deliver a first interest rate hike after the Covid-19 pandemic. The market expects UK interest rates to rise next year to the highest level since before the global financial crisis. It implies that the BOE will be much more aggressive than the Fed to tackle inflation.
In only two months, two-year Gilt yields have more than tripled, indicating that the market might be running ahead of itself. Consensus expects the BOE to hike by 15bps only instead of the more usual 25bps. Suppose such a rate hike is not supported unanimously by all MPC members. In that case, it may be a sign that an aggressive interest rate hike cycle might lack support.
The recent flattening of the Gilt yield curve shows that the bond market believes the imminent tightening of monetary policies will be short-lived. Indeed, the long part of the yield curve is close to inversion, with the spread between 10-year and 30-year Gilt yields trading around 7bps. If a slower pace of interest rate hikes is to materialize, we can expect the Gilt yield curve to steepen again.
The periphery is at risk with a hawkish ECB.
Last week’s ECB meeting sent shockwaves to the periphery. The BTPS-Bund spread spiked to 130bps, the highest since November 2020. To cause such a move is the perception that the ECB might not be as accommodative as it has been until now due to strong inflationary pressures. With the PEPP program ending in March next year, sovereigns from the periphery are at risk. Even if a new bond purchasing program is introduced, it might not provide as much support as the PEPP did until now.
The selloff continues this morning, with Italian BTPs recording the biggest losses as Citigroup and Goldman Sachs published research saying that the BTP-Bund spread will continue to widen. It's safe to expect the BTP-Bund spread to remain volatile until December’s ECB meeting. Yet, if yields don't stabilize, it's likely that the central bank will reiterate its commitment to keep financing conditions stable, compressing yields in the periphery once again.
Yet, it's essential not to forget that the German election is still playing in the background. If a traffic light coalition is confirmed, we'll likely see higher yields in the euro area. Yet, in the long term, the BTP-Bund spread will gradually tighten.
This week's it's worthwhile to keep an eye on government bond auctions from Germany, France and Spain to understand whether investors appetite for European sovereigns is changing.
Monday, the 1st of November
Tuesday, the 2nd of November
Wednesday, the 3rd of November
Thursday, the 4th of November
Friday, the 5th of November
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