Rates Spark: Getting over the headline

The inflation scare has eased as quickly as it rose yesterday but we fear fixed income is in the hand of developments in energy markets. It is well understood that central banks typically look through jumps in energy-related inflation but the recent spike is the latest in a list of worries that has pushed investors into inflation hedges. The data slate today should do nothing to alleviate fears although, here too, a spike in eurozone CPI should not come as a surprise thanks to well flagged base effects. In the eurozone, as is the case in other jurisdictions, investors would do better to track the trajectory of wages for signs of second-round effects.

Investors would do better to track the trajectory of wages for signs of second-round effects

That there should be no let-up in inflation-related headlines does not necessarily mean that rates are due to rise further today. A too rapid acceleration in prices can dent consumer spending power. What’s more, when inflation is as a result of insufficient supply capacity, the message about the economy’s growth potential is on balance negative. This should come as no surprise. In fact, this is exactly the sort of worry that gripped financial markets over the summer months. The difference compared to then is not a wholesale reappraisal of growth potential, but simply a more balanced supply and demand equilibrium thanks to a return to active primary markets.

As always, central bank policy is also playing a role. Even if purchases continue at full speed (or almost in the case of the ECB), US markets are now contemplating a rapid reduction between November 2021 and June 2022. Combined with more plentiful supply, and a tendency to price such shifts in advance, it is no wonder the US curve is staging a re-steepening attempt.

The focus is back on the upcoming policy divergence between the Fed and ECB next year

The contrast with the eurozone is becoming increasingly striking. That rates differentials widen in a sell-off is a foregone conclusion given the greater volatility of US rates, but it also puts the focus back on the upcoming policy divergence between the Fed and ECB next year. US markets face an abrupt end to purchases by mid-2022, followed by hikes in short order, while the ECB equivalent will continue at a healthy clip well into 2023 by most accounts. This is well understood but could have far reaching ramifications. For one thing, tighter USD conditions should achieve to widen cross currency basis. This is nowhere more true than against the EUR, which is set to become a more popular funding currency.