Articles
19 May 2021

Rates Spark: fear and hope

Investors will look at Fed and ECB communication today with fear and hope respectively. The fear is that a Fed U-turn threatens complacent USD rates. It will at some point, but probably not in today's minutes. The hope is that the ECB rescues EUR bond yields from tapering angst. It could, but not necessarily with faster PEPP purchases.

The fear factor in carry-dominated markets

Central bank communication remain the prime focus of rates markets with the April FOMC minutes to be published today, and with a reasonably heavy slate of ECB speakers. Investors are looking to the Fed with fear, while they are looking to the ECB with hope.

The Fed’s message has landed. This has resulted in stable but complacent USD rates markets

After months of repeating that it will be more reactive than proactive when it comes to dealing with signs of higher inflation, the Fed’s message has landed. This has resulted in stable but complacent USD rates markets. Much has been written about the discrepancy between abundant signs of rising price pressure and the calm, even sedate, US Treasury market. This has proved a boon for carry-oriented investing, but exposes the market to the risk of an abrupt change of tone at the Fed. This is particularly true in the sectors of the curve most sensitive to Fed policy, but also offerering the highest carry and roll-down, around the 5Y point.

5Y USD has stopped cheapening on the curve, and remain too low outright

Source: Refinitiv, ING
Refinitiv, ING

Judging from recent public comments by FOMC members, such a change in policy is not imminent. FOMC minutes are by their very nature backward-looking, so opinions voiced there should in theory have been made public, at least in case of major dissent. What’s more, it seems to us that there is a wide consensus behind the tone struck by chair Jerome Powell. The fear is thus that this state of play comes to an abrupt end with a change of tone at the Fed. We think it will but now is not the time. Noisy economic data has lent the Fed’s argument more heft.

Hope for a comfort blanket for rising EUR yields

In contrast, we think EUR rates markets are looking toward ECB communication with hope. With the default expectation among investors being that PEPP purchases will have to be phased out into the end of the programme, planned for March 2022, it seems to us that only the ECB has the power to stop the accelerated rise in sovereign bond yields. Besides delaying the eventual slowdown in PEPP purchases, an alternative route would be to boost APP purchases, say by €20bn/month to €40bn/month. It is unlikely that the combined purchases will entirely make up for the end of PEPP, but APP is strongly linked to inflation, so it could remain in place much longer.

There is still a hefty amount of supply to be had this week

Meanwhile, issuance continues its sapping work under sovereign bond markets. May has marked a clear acceleration in the sell-off into large deals such as the EU’s dual tranche syndication yesterday. There is still a hefty amount of supply to be had this week with 10Y sales from Finland and Germany today, and more from Spain and France tomorrow. We tend to regard the market impact of supply as transitory in normal times but, in the current environment, they compound fears of lesser central bank support.

€53bn

The EU supply in excess of ECB purchases this year

Private investors will need to make up for the shortfall

Unlike the sovereigns it has been set up to finance, EU supply will not be offset entirely by ECB purchases this year. We estimate the shortfall to be in the region of €50bn. This has led to discussion that slightly less stellar than earlier debt sales metrics were a warning sign of waning demand. We beg to differ. For one thing, there has been a degree of moderation in the size of order books across sovereign syndicated deals this year. For another, the moderation is merely the predictable end of the hype that surrounded previous EU deals. We have little doubt that subsequent sales will meet healthy demand, even if market impact on wider EUR rates might be felt more acutely due to the economic recovery backdrop.

2021 projected bond supply from Eurozone governments and Supranationals

Source: ING forecast
ING forecast

Today’s events and market view

The FOMC minutes released today are the main hawkish risk for rates markets, as expectations for a change of tone are rock-bottom. We tend to agree, but too strong a display of optimism or concerns about an overheating economy would be enough to unsettle US Treasuries.

ECB speakers should also garner a large share of the attention heading into the decisive June 10th meeting. The most prominent of them scheduled today is chief economist Philip Lane.

Finland mandated banks for the sale of a 10Y benchmark, €3bn deal, which will add to scheduled 10Y supply from Germany and 20Y from the US.

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