Rates Spark: The Fed builds while the ECB monitors

Treasuries had their post presidential debate mini-tantrum, but have calmed since. The 10Y is back in the 4.25% to 4.30% area, and looking for an excuse to dip lower. The rationale for doing so can come from Thursday's CPI report for June. The May report had enough there for us to pivot from being bearish on Treasuries to positioning for a more definite rate-cutting tendency ahead. Our view having seen that report was that it was repeatable in June, and beyond. If that is the case, the rate cut discount for September can harden further.

We're now at an 80% probability for a 25bp cut, which is a decent enough discount. Chair Powell has an opportunity to impact that discount should he choose, but we suspect not. The build in that discount refers to the same data as he is looking at, and most of it has softened since the last FOMC meeting. What is remarkable is the low ebb to volatility and the risk-on backdrop. Typically when everything looks rosy things go wrong, so we'll keep and eye on it.

There are auctions to get through in the coming days, 3's, 10's and 30's. The 10's and 30's in particular need to be watched. A heavy reception can frustrate efforts to get lower in yield, but we suspect we'd need to see a surprise upside to the CPI report on Thursday to really trouble Treasuries here. Typically the build of a rate cut discount and delivery of it is a time when being long is the safest bet.

Meanwhile, we also note latest data showing a fall in bank reserves to $3.2tn. That's still elevated, but any tendency to break below $3tn in the coming weeks would point to a tightening in liquidity conditions that can have ripple effects. We find this a bit strange as there is still some $400bn going back to the Fed on the reverse repo facility. That should really fall first before reserves take up the slack, the rationale being that posting cash back at the Fed is a pre reflection of excess liquidity; unless it can be explained away by inertia (players just keep doing what they have been doing, and just post at the Fed).

Whereas in the US we see the rate-cutting narrative picking up momentum, in the eurozone the direction is less evident. The 10Y Bund yield is close to 2.5% again, a handle around which it has been trading since April. The data in the eurozone has simply been more mixed regarding the direction of the economy, with headline inflation coming down, services inflation and wage growth remaining stubborn, and labour markets showing few signs of deterioration.

We still think the next cut by the European Central Bank will be in September, but this does not have to signal a series of consecutive cuts. The June cut was a hawkish one and should also be seen separately from a full easing cycle. Markets are reluctant to price in two more cuts for this year and we too think more data is needed to support that. This also means that the front end of the curve can remain anchored for longer than in the US, thereby limiting the steepening potential of the 2s10s of Bunds in the near term.

French spreads compressed a couple of basis points on the back of the election results, though it’s too early to draw strong conclusions in our view. The path forward has only turned blurrier and with the left coming out stronger than expected the fiscal deficit is unlikely to take priority. Also the consequences for the EU as a whole is not clear-cut because both the left and right in France are known to boast anti-EU rhetoric. We would not be surprised if OAT spreads widen from here since the political system has little experience with the current state of play and thus the outlook is one of volatility.