Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
Fixed income market: the week ahead
Althea Spinozzi
Head of Fixed Income Strategy
Summary: Inflation is driving the bond market and monetary policies. Therefore, this week's inflation readings out from the US and Germany and long-term bond auctions in the US, Germany and Italy can be catalysts for a deeper selloff in the government bond space. In the US, long-term Treasuries aren't benefitting anymore from support coming from the debt-ceiling issue, leaving 10-year yields free to rise towards 1.70%. Gilt yields will continue to soar in the UK, and the yield curve will flatten as investors price early interest rate hikes. In Europe, government bonds are feeling the same pressures at play in the US and the UK. Besides German inflation readings on Wednesday, the 30-year Bunds and 30-year BTPS auctions will be in focus as weak bidding metrics could intensify bearish sentiment in the European sovereign space.
US Treasuries are poised to suffer this week.
Last week, the debt ceiling was extended until December, removing critical support for long-term Treasuries.
The debt-ceiling provided critical support for long term US Treasuries as they were providing safety amid a spike of volatility in money markets. Now that the US isn't running any longer into an imminent risk of default, the flight to safety, which was capping long term yields, has been removed. It means that US yields are free to rise amid this week CPI readings and long term bond auctions.
The nonfarm payrolls report on Friday did little to deter bond bears. Although the economy added just 194,000 jobs, the lowest since the beginning of the year, 10-year yields rose to break their resistance at 1.60%, showing that investors are focusing more on inflation rather than jobs. Indeed, unemployment fell more than expected to 4.8%. At the same time, the monthly average hourly earnings remain elevated, hinting at lasting inflation ahead.
That’s why the consumer price inflation data coming out on Wednesday are crucial for the bond market. Economists expect the CPI for September to match the one of August, showing a monthly increase of 0.3%, leaving the annual inflation gain at 5.3%. Any surprises on the upside could provoke yields to continue their rise towards 1.70%. According to a Bloomberg report, with 10-year yields above 1.60%, the bond market runs into the risk of convexity hedging. Convexity hedging happens when Mortgage-Backed Security (MBS) holders need to sell long-term bonds to decrease the duration of their overall portfolio. If that were the case, 10-year yields could quickly rise to test their yearly high at 1.77%.
Always on Wednesday, the US Treasury will sell 30-year bonds, and the FOMC Minutes will be released. They have the potential to apply even more pressure on the long part of the yield curve. Investors will be addressing the FOMC Minutes carefully, trying to understand what Jerome Powell meant last month when he said he'd need to see a "decent” jobs report to taper in November. We believe that despite the weak nonfarm payrolls, there are clear signs of recovery in the labor market. However, inflation is becoming a more pressing issue, forcing the central bank’s to finally taper.
Producer price inflation on Thursday and retail sales on Friday will also be important. Retail sales are expected to have decreased due to a plunge in vehicle sales caused by supply-chain disruptions. That's why it will be essential to look at these numbers in detail: as vehicle sales drop, other retail sales might rise.
Gilts will continue to tumble.
This week is going to be a pivotal week also for the UK. The British economy is slowing down while inflation expectations rise due to supply chain disruptions and staff shortages. Therefore, the market’s focus will be on Tuesday’s unemployment and wage data and Wednesday’s GDP, industrial and manufacturing data.
During the weekend, BOE’s Michael Saunders said in an interview that households should get ready for “significantly earlier” interest rate hikes, putting even more pressure on Gilts. The bond market reacted badly to the news this morning. Ten-year Gilt yields opened at 1.19%, the highest since May 2019. Two-year gilts rose to 0.60%, the highest since January 2020. As inflationary pressures become more pronounced, we anticipate yields to continue to soar and the yield curve to flatten as investors price early interest rate hikes.
The Gilt-Bund spread widened to 130bps, a level previously seen in 2016. We expect this spread to widen as much as 150bps as the market prepares for BOE’s interest rate hikes. However, by the end of the year, the Gilt-Bund spread is likely to narrow to current levels as inflation expectations, the German election and higher yield in the US will force Bund yields higher.
European sovereigns feel the inflation heatwave, too.
European government bond yields are feeling the same pressures as in the US and the UK, with one exception: the eurozone yield curve is not pricing rate hikes until 2024.
This morning 10-year Bund yields opened at -0.13%, breaking above their resistance at -0.15% for the first time since July.
We expect European yields to soar together with yields in the US this week. The German ZEW Economic sentiment on Tuesday and inflation readings on Wednesday might be catalysts for more volatility. To make things worse, the German DMO office will issue 30-year Bunds testing market appetite for duration.
Always on Wednesday, Italy will sell 3-year, 7-year and 30-year BTPS testing market appetite for the periphery. Any weakness in biding metrics could intensify the selloff within the European bond space.
Economic Calendar
Monday, October the 11th
- United States: Columbus day- the bond market is closed
- Italy: Industrial Production
Tuesday, October the 12th
- Japan: Bank Lending, PPI MoM (Sept), 30-year JGB Auction
- Australia: NAB Business Confidence (Sept)
- Germany: Wholesale Prices (Sept)
- United Kingdom: Claimant Count Change (Sept), Average Earnings (Aug), Employment change (July)
- Eurozone: ZEW Economic Sentiment Index (Oct)
- Germany: ZEW Economic Sentiment Index (Oct), 2-year Schatz Auction
- United States: NFIB Business Optimism Index (Sept), JOLTs Job Openings (Aug), NY Fed Treasury Purchases 10 to 22.5 years, Consumer Inflation Expectations (Sept), 3-year Note Auction, 10-year Note Auction
Wednesday, October the 13th
- Japan: Reuters Tankan Index (Oct), Machinery Orders (Aug)
- Germany: Harmonized Inflation Rate (Sep), 30-year Bund Auction
- United Kingdom: Balance if Trade (Aug), GDP 3-month avg (Aug), Industrial Production (Aug), Manufacturing Production (Aug), GDP (Aug)
- Eurozone: Industrial Production
- Italy: 3-year, 7-year, 20-year and 30-year BTP auction
- United States: MBA 30-year Mortgage Rate (Oct), Inflation Rate (Sept), NY Fed Treasury Purchases 4.5 to 7 years, 30-year Bond Auction, FOMC Minutes
Thursday, October the 14th
- Australia: Westpac Consumer Confidence Index (Oct), Employment Change, Full-Time Employment (sept)
- China: Inflation Rate (Sept), PPI (Sept), M2 Money Supply (Sept), Total Social Financing (Sept), Outstanding Loan Growth (Sept)
- Japan: Industrial Production (Aug), Capacity Utilization (Aug)
- Spain: Harmonized Inflation Rate (Sept)
- Canada: Manufacturing Sales (Aug)
- United States: Initial Jobless Claims (Oct), Jobless Claims 4-week Average, PPI (Sept), NY Fed Treasury Purchases 22.5 to 30 years, 4-week and 8-week T-Bill Auction
Friday, October the 15th
- Australia Consumer Inflation Expectations (Oct)
- Eurozone: New Car Registrations, Balance of Trade (Aug)
- France: Harmonized Inflation Rate (Sep)
- Italy: Harmonized Inflation Rate (Sep), Balance of Trade
- Canada: PPI (Sept), Wholesale Sales, New Motor Vehicle Sales
- United States: Retail Sales (Sept), Import Prices, Export Prices, NY Empire State Manufacturing Index (Oct), Business Inventories (Aug), Michigan Consumer, Inflation, Current Conditions (Oct)
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