Head of Fixed Income Strategy
Summary: Although Friday's US jobs miss supports the Federal Reserve's view that the economy needs support for longer, the bond market tells us that inflation is the only mantra. This week's monthly CPI data will be in focus. While economists expect the CPI to rise to 3.6% YoY, the market knows that this figure will be transitory due to shocks provoked by last year's lockdowns. However, a strong monthly CPI reading may not be transitory. Hence, any surprise in the monthly CPI numbers may cause US Treasury yields to resume their rise towards 2%. In Europe, the ECB June's meeting is gaining more importance as the central bank's members are vocal about continuous economic support. However, their dovish stance will not be enough to keep European sovereign yields in check if yields resume their rise in the US. The Scottish elections failed to move Gilts, and ten-year yields continue to be stuck at 0.8%. Our focus turns to tomorrow's 2061 Gilt issuance.
CPI readings may poke bond vigilantes
Friday's nonfarm payroll miss left investors in shock. Is the Federal Reserve right to continue to stimulate the economy until we see a string of solid jobs reports? How does that go with strengthening inflation data?
I believe that these questions can be answered by the prominent move that we have seen in US Treasury yields on Friday as the jobs numbers were released. The chart below shows how US Treasury yields traded intraday on Friday. Upon the jobs miss, ten-year yields dropped ten basis points but immediately reversed their losses, closing flat on the day. The move tells us that there is only one crucial economic data for the bond market: inflation.
This is why Wednesday’s CPI data and Treasury auctions will be in focus this week.
While the US economy struggles to recover jobs, commodity prices continue to surge, with the Bloomberg Commodity Index hitting a new high level in years almost every day. Last week, breakeven rates rose to new high levels, with the 10-year Breakeven breaking above 2.5% for the first time since 2012 while the 5-year Breakeven rate rose to 2.70%, the highest since 2008.
The market starts to accept the core message of the Average Inflation Targeting (AIT) framework: despite inflationary pressures continue to strengthen, the Fed will remain impassively dovish. Within this context, bond vigilante might soon start to dump US Treasuries as the risk of a Fed’s monetary policy mistake is rising together with inflation expectations.
Therefore we believe it is necessary to watch out for catalysts that may renew a selloff in US Treasuries. One of them could come as soon as this Wednesday if monthly CPI data comes stronger than forecasted. The market is expecting a 3.6% YoY rise of CPI, the highest since 2011. However, the monthly CPI reading will be more critical because while yearly inflation following the pandemic will be transitory, the monthly may not be.
The 3-, 10- and 30-year Treasury auctions between Tuesday and Thursday will also be important. Our attention is focused on bidding metrics and foreign demand in particular, which is lagging since the beginning of the year.
Are European sovereign yields in check?
In Europe, the focus continues to grow around June’s ECB monetary policy meeting. Today, the central bank's Chief Economist Philip Lane said that the PEPP program could be adjusted in June. He hints at the fact that it may be extended because the economy will most likely require monetary support. Also critical is the recent comment made by the governor of Finland's central bank, Olli Rehn, who said that the ECB should adopt the Fed's AIG framework. Both comments highlight the inclination of the ECB members to provide the central bank with more flexibility to continue purchasing European bonds amid the economic recovery. However, we believe that increased dovishness will not keep in check European sovereign yields because EU government bonds remain tightly correlated to US Treasuries. Therefore, until the german election, European yields will remain vulnerable to changes in US yields. Once US Treasury yields resume rising, we might see a rotation from EU Sovereign to the US safe-haven materializing. Yet, the German election will ultimately push yields higher, provoking Bund yields to turn positive. In the short-term, Bund yields could break below the lower uptrend line of the ascending wedge they have been trading in since March and find new support at -0.40%. However, if they break above -0.15%, they could rise fast to 0%.
Gilts remain stuck at 0.80%, but not for long
UK Gilts are stuck at 0.80% since February. The Scottish elections have failed to give direction. Still, we believe that yields are poised to go higher as the economic backdrop continues to strengthen. On Wednesday, the GDP results will be in focus, and a high read may help 10-year Gilts to break above their resistance line at 0.85% to resume their rise at 1%. While we believe that it is inevitable for Gilt yields to continue to rise, we are still convinced that the BOE will watch at them closely. With the most hawkish member, Haldane, leaving in June, any rise in yields above 1% might increase worries regarding the corporate sector, which is not weakened by the Covid-19 pandemic, but by Brexit, too. Tomorrow HM Treasury will issue 2061 Gilts. We expect the issuance to be well received because real money is still in desperate need of yield. They recently provided wide support for the recent 30-year issuance, which priced around 1.31%.
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