Rates Spark: Bonds under pressure now but looking to cuts

Bonds face an interesting combination of supply and improving sentiment towards the US regional banking sector. Debt ceiling angst, the third non-macro driver of bonds at the moment, is ever present in the headlines but we think their impact into broader markets, that is beyond money markets, is muted for now. This may not last. Risk appetite towards the banking sector is notoriously unstable, and the Fed’s Michael Barr’s testimony tonight may well put the issue back on the market’s mind.

A return of optimism may well bring pent-up bond issuance to primary markets.

Barring another spike of banking worries, however, we think this supply window may well extend. Supply typically affects the market on a short-term basis. Selling pressure should in theory be front-loaded to the start of this week, but a regain of optimism may well bring pent-up bond issuance to primary markets, all to the detriment of secondary market bond direction.

A further tactical sell-off is our base case, although the top of the recent range in yield is approaching fast and we doubt there is enough risk appetite to justify breaking out of recent ranges, especially to the upside. It is true that our view, that the economy is heading for a hard landing which will force the Fed to cut rates, is now mainstream, but we doubt Treasuries have already run out of buyers. In fact, we think we’re just about to enter a phase of banks and other institutions falling over themselves to call the date of the first cut. This should, to an extent at least, support the bid into Treasuries and send much of the 2-10Y maturities much closer to 3%.

Markets have a date with economic reality today, in the form of hard economic data out of the US, namely retail sales and industrial production. We doubt these will provide the smoking gun for the Fed to embrace market cut expectations (hence our bearish tactical view above). Instead, it is in Europe that hard economic data has proved the most relevant to rates direction. We credit, or blame depending on how one wants to look at it, them for market ignoring hawkish warnings by various European Central Bank (ECB) officials.

Investors seem more amenable to the dovish message

Instead, investors seem more amenable to the dovish message, that this hiking cycle will soon draw to an end. Yannis Stournaras was expressing this view as recently as this morning in an interview. Interestingly, consensus for today’s German Zew is for a third consecutive decline in the expectations component, and the second decline in the current assessment since the index bottomed in October last year. It is hard to draw a conclusion on a single data point but it could be a case of market sentiment catching up to hard economic data, for instance dismal industrial production, rather than the opposite as intuition would suggest.

No wonder that markets are listening to the ECB doves more than to the hawks. A counterpoint to this is that it seems markets are getting numb to both sides of the argument, given the deluge of public comments made since the May meeting. For instance, MNI cited internal ECB sources as saying a September hike is viewed as unlikely. This runs counter to more hawkish press briefings. One reason for the lack of reaction might be that there will be two updates to the ECB’s staff forecast by then, so policy opinions expressed four months before the September meeting are treated as just that, opinions.