Rates Spark: An ECB pause, but no relief for longer rates

Markets have been firm on their view that the ECB will not hike rates at today’s meeting since the ECB indicated in September that rates were high enough to bring down inflation. The latest economic data points only brought further confirmation, with the PMIs pointing to worsening weakness in the economy. The bank lending survey and data also indicate that the transmission of the ECB’s policy tightening is working. Overall, a good time to pause, and our economists also agree.

This will put even more focus on the ECB’s signalling and how it sees the balance of risks surrounding inflation and growth. Geopolitical tensions in the Middle East and with it, elevated oil prices have brought renewed concerns around the viability of the ECB’s plans to reach its inflation target with current policies in a timely manner. Since the end of last week, oil prices have started to ease, though uncertainty still appears elevated surrounding the region. Currently, markets are fully discounting a first 25bp rate cut around the middle of next year. Some hawkish ECB members such as Klaas Knot seem to think this is still too early.

Bringing the focus of discussions back to the ECB’s balance sheet might be a possibility to maintain a hawkish posture and prevent markets from pricing cuts too early. However, higher long-term rates, even if more inspired by US rates, might lessen the pressure on the ECB. And any balance sheet discussion will also have to be balanced against the growing concerns surrounding sovereign spreads, and Italy in particular. Spreads of Italian bonds over Bunds had seen some relief following the affirmation of Italy's sovereign rating by S&P last week, but have since moved back above 200bp. This may be indicative of market expectations for the ECB working towards stopping Pandemic Emergency Purchase Programme reinvestments earlier than is currently planned. At the moment, reinvestments are still slated to run until at least the end of 2024.

US rates had seen a rally at the beginning of the week, but the long end has begun pulling the curve higher and steeper again – the 10Y yield is back above 4.9% and 30Y yields firmly above 5% again. One factor may be today’s data where markets are looking for a solid 4.5% third-quarter GDP reading, boosted by strong consumer spending. However, we would note that the front end is proving relatively stable with the 2Y UST yield resisting a rise above this week's highs of around 5.13%. Late last week, the 2Y had reached 5.25%.

The other factor then is of course supply. Not necessarily today’s 7Y Treasury auction which follows on the heels of last night's weaker 5Y auction, but the US Treasury Department’s next quarterly refunding statement where it lays out issuance plans for the next three months. The detailed announcement will come on 1 November.

Back in August, the higher-than-expected announced issuance volumes were seen as a key factor turning the market bearish on rates and driving the so-called term premium – i.e. the excess yield investors require to commit to holding a long-term bond over the expected path of short-term yields over the same horizon.