Rates Spark: bye bye hikes

Even accounting for a fair dose of confirmation bias, the rally in front-end rates this week is nothing short of spectacular. Once again, global rates markets are taking their cues from the US, where a more nuanced Fed tone was enough for bond yields to dive, and for curves to bull-steepen. Of course, a miss in US 2Q GDP added to buying pressure at the front-end, but we think the underlying conviction that the looming recession will scupper central banks’ efforts to tighten policy is to blame.

The looming recession will scupper central banks’ efforts to tighten policy

To be clear, we do agree with recession calls and have long argued that the amount of hikes priced by the EUR and GBP swap curves were excessive. Throughout the bond sell-off, our economics team has called for no more than 100bp of hikes from the ECB in this cycle, compared to market pricing of more than 300bp at some point. This is to their credit. The market adjustment lower is probably closer to its end than to its beginning but we see more downside risks to rates on account of 1) risk aversion drawing more money into the relative safety of bonds, and 2) as the EUR curve still needs to price out roughly 50bp of hikes by the end of this year.

Of course, this adjustment will be far from a smooth journey. The upside surprise to Germany’s July CPI, as well as our forecast for persistently high inflation over the coming months, means some of the recent rally could well be reversed, in particular if eurozone core inflation released today accelerates as forecast. As a result, we think the size of the drop in rates at the long end might be smaller, but the transition looks to be smoother. We wouldn’t be surprised to see Bund yields test the 0.5% level by the end of this summer.

Our forecasts have CPI returning below the 2% target as soon as the end of next year

That policy dilemma is also one faced by the Bank of England. An upside surprise in inflation and a still robust job market tip the scales in favour of a 50bp hike at next week’s meeting, but this may well be the last hike in this cycle. Our economics team summarised the factors affecting the Bank’s decision in a handy article but, overall, they boil down the already high rates and looming recession risk cementing its expectations for lower inflation. Our forecasts have CPI returning below the 2% target as soon as the end of next year.