Rates Spark: keep an eye on the long-end

The gloom pervading in financial markets was uninterrupted overnight as further covid-related restrictions dominated the headlines in Germany and France. There was little to challenge monetary easing expectations either with Villeroy and De Cos both raising the possibility of more stimulus. 10Y German yields are on track to fall below our pre-ECB target of -0.60%, making a move to -0.70% increasingly likely.

In the US, the expectations of near term fiscal stimulus were kept on life support by comments from both camps, likely because no one wants to be seen as pulling the plug on the talks. As US Treasuries seemed happy to rally alongside Bund of late, we surmise expectations remain fairly low.

There is very little on today’s calendar to provide new impetus to markets save for potential headline risks around the EU summit starting this afternoon and concluding tomorrow morning. This can suggest two things. Either the lack of headlines will contribute to a reassessment of the record low levels reached by EUR rates in the past sessions, or it will see an extension of the existing trend.

We’re in the latter camp. The basis for the rally (by which we mean move lower) in EUR rates is a combination of dovish central bank tone and deteriorating economic outlook on the back of more stringent social distancing/lockdown measures imposed to European economies. We do not expect any of those narratives to reverse in the near future. On the contrary, recent public comments suggest even hawks are coming around to the idea of easing (but there will be an intense debate about its form).

Our economics team, and the vast majority of its peers still has December as the most likely date for ECB easing but we would not be surprised that some portfolios with a large interest rates exposure hedge against the risk of easing in October. Even if a low probability event, the impact a dovish surprise could have on participants with a structural long-end paying position would be significant enough that some receive at the long-end into the meeting.

This environment of EUR rates breaking out of their recent ranges warrants monitoring the curve for non-linear dynamics. We expect that while rates were range-bound, roughly speaking since June, dynamic hedging of large rate portfolio was fairly muted. We are on the lookout for these to resume, which would benefit 30Y EUR swaps the most in our view.

Two market indicators in particular seem at risk of reversing in our analysis. We’re expecting a re-tightening of 30Y asset swap spreads (swaps outperforming cash) to 5bp, from 12bp currently, in case of a resumption of long-end swap receiving activity. The same dynamics would cause a re-flattening of EUR 10s30s to 18bp, from 23bp.

Austria mandated banks yesterday for the sale of a new 20Y issue. This will come on top of Spanish (new 5Y) and France (5Y/6Y/7Y and Linkers).

The calendar is void of tier one European economic releases in the morning but the afternoon brings US jobless claims and some regional surveys (Empire manufacturing and Philly Fed).

Lagarde is the sole ECB speaker schedued today, among more numerous Fed officials.

The EU council starts its two days meeting this afternoon with Brexit high on the agenda.