Head of Fixed Income Strategy
Summary: This week's US CPI prints will be in the spotlight as they may force the Federal Reserve's hand about a tapering decision next week. Consequently, the US yield curve may bear-flatten despite the Fed previously soothed interest rates hikes expectations. As foreign demand for US Treasuries remains robust, ten-year yields are unlikely to move outside their year-to-date monthly standard deviation amid an inflation surprise. To strive, bond bears need a tapering announcement. In Europe, we expect yields to remain stable after last week's ECB dovish taper. Heavy bond supply might bring about slightly steeper yield curves: Italy and Spain will issue long-term bonds on Tuesday and Thursday, respectively. Gilts are at risk as inflation is expected to hit a three-year high at 2.9% in the UK.
Before looking at what market event will drive volatility this week, it's worth spending a few words on Friday's Producer Price Index figures. US PPI hit 8.3%, the highest annual rate since 2010. This data raises questions, once again, whether inflation is truly transitory. By buying $120 billion worth of bonds and MBS monthly, the Federal Reserve continues to stimulate inflationary pressures, posing a policy mistake threat. Therefore, why the Fed stubbornly sticks to its accommodative stance?
Inflation might be the only element that could force central banks out of their accommodative stance; that's why tomorrow CPI numbers are critical to the bond market. The consensus believes that inflation might be peaking. The yearly figure is expected to come at 5.3% year-on-year and 0.4% monthly. If inflation exceeds expectations, doubts about the transitory nature of inflation may arise, prompting the Fed to opt to announce tapering as soon as next week.
Yet, how much volatility can we expect in the bond market out of tomorrow CPI numbers? Bond bears might be disappointed once again. Indeed, demand for US treasuries continues to be exceptionally robust as foreign investors see the convenience to lock-in a considerable pick-up by buying into the US safe-havens. Japanese investors get roughly 100bps over JGBs by buying JPY-hedged US Treasuries. At the same time, European investors are still able to get 90bps over the 10-year Bund by buying into EUR-hedged US Treasuries. That's why indirect bidders demand was stellar at last week’s 10-year and 30-year Treasury auctions, prompting a US Treasuries rally.
Thus, if CPI numbers surprise on the upside, it's safe to assume that 10-year yields will not rise more than their monthly standard deviation since the beginning of the year of roughly 5bps. Only twice this year, 10-year yields rose 10bps or more over a day in February amid the reflation trade. It suggests that bond bears still need a tapering announcement and interest rate hike expectations advancing to match the volatility earlier in the year.
A strong CPI report might lead 10-year yields to break above their 200 days simple moving average, pushing yields close to 1.40%. However, a fall in retail sales on Thursday might reverse their rise. Thus, Treasury yields might change little from current levels ahead of next week's FOMC meeting. Looking at the US yield curve, we expect it to bear-flatten amid a high CPI print, although the Fed has anchored rates hikes expectations.
We remain of the opinion that inflationary pressures justify an early Fed taper. The later a tapering decision is taken, the swifter a taper needs to be, and interest rate hikes to occur earlier, provoking a much deeper selloff in the bond market. Indeed, five-year and ten-year breakeven rates broke above their 100 simple days moving averages last week in a sign that supply-chain issues, rising labor costs, and corporates' ability to pass on inflation to their customers are causes of more persistent inflation.
We expect the European government bond space to remain calm until the German election or US yields resume their rise. The ECB delivered a dovish taper successfully, providing ample support to bond supply and carry trades during the mid-term.
However, yield curves could steepen slightly this week as bond supply is expected to surpass EUR 30 billion. Italy starts off selling 3-, 7-, and 30-year bonds through an auction tomorrow. On Thursday, Spain will sell 3-, 5- and 10-year bonds. Finally, the European Union sent an RfP last week informing that it will hold three more syndicated transactions in September, October and November to raise money under the NextGenEU fund.
The UK will be more in the spotlight than Europe this week. Inflation is expected to hit a three-year high at 2.9% in the UK, paving the way to a hawkish Bank of England's monetary policy meeting next week. The MPC looks split regarding whether economic conditions for a hike have been met. Thus, strong inflation numbers might be crucial to a decision next week. After 10-year yields quadrupled at the beginning of the year, they began to fall amid a wave of Delta variant. As the economy reopens and inflation runs hot, we can expect yields to resume their rise towards 0.90%.
Monday, the 13th of September
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Wednesday, the 15th of September
Thursday, the 16th of September
Friday, the 17th of September
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