Rates Spark: Keeping upward pressure on the front end

The ECB has lived up to the hawkish expectations, especially on the back of having revised up its own inflation forecasts. In the press conference, President Christine Lagarde used the words we have become accustomed to, that “more ground needs to be covered”. And she heavily hinted at another hike in July.

The initial reaction to the ECB decision saw a strong bear flattening of the curve. Note that it mainly comes from pricing out 2024 cuts than pricing in a higher terminal rate. That move later faded somewhat, but 2Y Bund yield still ended 10bp higher on the day, while the 10Y yield was up by 5bp and thus stayed shy of its recent highs at 2.55%. The 2s10s curve now stands at close to -63bp, its most inverted since the banking turmoil in March when the curve briefly hit -73bp.

The market will have to account for the increasing probability that the ECB's narrow inflation focus eventually results in a policy error

The inversion is reflective of the ECB having to straddle persistently high inflation on the one hand, but also already weakening economic data on the other. The way the ECB deals with it is to focus on the former while being quite optimistic about the latter. That optimistic view on the economy also gives it more room to keep tightening, keeping front-end yields elevated. But the market will have to account for the increasing probability that this narrow focus on current inflation to determine the ECB's success results in a policy error further down the road. Hence the reluctance in longer rates to follow the front end higher.

As a final note, the ECB confirmed that APP reinvestments will end in July. Lagarde signalled that ECB was not worried about the declines in excess reserves in the banking system also with the €477bn TLTRO redemption coming up at the end of this month. Today the ECB will also announce any further voluntary TLTRO repayments from banks.

That tension between persistently high inflation and recession fears is of course a wider and ongoing market theme. Indeed, yesterday’s market reaction to the ECB and the quick fade was probably more down to mixed US data releases that came out just when Lagarde was set to speak.

Central banks this week have given themselves the flexibility and room to tighten policies further

More hints that US pipeline pressures are easing came from import prices falling faster than expected. And we also saw the weekly jobless claims grind higher again suggesting a softening of the jobs market. As our economist notes, probably not enough to deter the Fed from a potential hike in July following the hawkish pause this week, but enough to keep the market concerned about the outlook. As opposed to the bear flattening in EUR, the US curve bull flattened with the 10Y UST yield dipping towards 3.7%

Overall, central banks this week have given themselves the flexibility and room to tighten policies further should data warrant it, keeping upward pressure on front-end rates. Yield curves could invert further but given how far they already stretch, long-end rates could still follow higher in the near term.

Only the Bank of Japan (BoJ) bucked the hawkish trend set by the Fed and ECB (and likely continued by the BoE next week) today by leaving policy rates unchanged and dismissing calls for an adjustment higher of its yield curve control cap, currently standing at 0.5%. The lack of action today and the view put forward that the current spike in inflation will prove temporary leaves the market guessing about the timing of a potential normalisation of the BoJ's policy setting.