Rates Spark: First round but then one more to go

As we head into the last trading day before Sunday’s French elections, markets can look back at still elevated levels but otherwise a relatively calm week. We expected more volatility, but the moderating tones from France’s populist party leaders helped stabilise sentiment. Having said that, the game is not over. Marine Le Pen is leading with 34-36% in the polls, yet it’s the second round a week later that really counts. EGB spreads will therefore remain elevated and volatility could even pick up. Since no outcome has the prospect of solving France’s fiscal challenges, we do not see scope for much OAT spread tightening going forward.

If the coming weeks were to trigger a significant spread widening of French government bonds, we do not expect the European Central Bank to be quick to interfere. Over the past few years, market discipline has bound politicians to budgetary reason, with former UK Prime Minister Liz Truss a peak example. The European Central Bank has little incentive to dampen this effect. And just yesterday the German finance minister highlighted that any strong intervention may not be in line with legal treaties, so the political appetite may also be lacking.

US rates inched lower yesterday, with the 10y US Treasury yield below 4.3% again. The core durable goods report showed a contraction in May, whilst expectations were still for month-on-month growth. Also, continuing claims data was weaker than consensus, which could be a leading indicator for a rising unemployment rate, an important data point that will be released next week. The Federal Reserve still has been more hawkish in tone recently, but if unemployment numbers show a notable deterioration this will help support a September rate cut.

Having said that, the US PCE reading today will be more important to yields than underlying growth dynamics. Because the PCE is composed of many price measures that have already been published earlier, there is a high confidence that the core month-on-month number will land between 0.1% and 0.2%. In our view, both readings would be acceptable for the Fed’s cutting narrative to build further and thus we remain bullish on USTs.