Rates Spark: Losing its cool

This week has brought a subtle change in market behaviour that may well extend into the coming sessions: USD rates seem to have lost some of their cool. If our economics team’s expectation for a 500k May payroll figure in this Friday’s report is any guide, we doubt the strength of the labour market has anything to do with it. And indeed, the labour component in ISM Manufacturing yesterday reinforced fears that supply constraints may be holding back further gains.

We see the real culprit as being increasingly persistent taper talk. More and more officials are publicly drawing the conclusion that bottlenecks, an erstwhile reason for caution, are now an argument to start the tapering debate. To be clear, the tone is still cautious, and we expect any announcement to take place no earlier than at the Jackson Hole symposium in August. Nevertheless, we think this is enough to bring a change in narrative in rate markets, whereby concerns over increasing price pressure and bottlenecks are no longer shrugged off by USD rates.

And the taper talk comes against a backdrop where the Federal Reserve continue to take in considerable liquidity in its reverse repo facility. It has eased back down to the USD 450bn area, but this is still a considerable amount, especially outside a month- or quarter-end. The fact that the volumes going back to the Fed are a tad lower takes some pressure off, but the volumes themselves remain large.

The Federal Reserve continue to take in considerable liquidity in its reverse repo facility

This continues to coincide with downward pressure on front end rates generally, in turn coming from the build in implied excess liquidity generated by the Fed's ongoing ultra easy policy. This continues to provide considerable support for the US system (e.g. 3mth Libor at or close to historical lows), and by extension for the economy.

This remarkable support is at the very least providing the economy with the best chance of complete recovery. Real yields remain unresponsive through, remaining more reflective of extreme stimulus than of a discount for sustained recovery.

The European Commission (EC) announced yesterday that the first bond issuance to finance its recovery fund (dubbed NGeu) will take place in June. Separate sources had the size of this first syndicated deal at €10bn, which is consistent with SURE bond sales earlier this year. The EC also added that €80bn of long-term bonds, which it defines as having a maturity longer than 3Y, will be sold this year. This is greater than our initial forecast and reflects earlier timing for the first deal.

We doubt that the most risk-adverse investors will put it in the same liquidity category as sovereign debt

Comments putting the EU bond market on par with the largest Euro sovereigns have to be taken with a generous helping of salt. The fund’s target size of €750bn at 2018 prices compares with the €2.2tn of Italian sovereign debt. The same figure is €2.1tn for France and €1.5tn for Germany. What's more, the temporary (at least on paper) nature of the NGeu programme means we doubt the most risk-adverse investors will put it in the same liquidity category as sovereign debt.

This is not to downplay its importance however. EU net bond issuance upwards of €100bn next year will compare to €320bn for the whole of the EUR government bond (EGB) complex. We do not doubt the market’s ability to absorb this amount of debt but it bears looking at public finance announcements as 2022 deficit forecasts firm up. Should sovereigns fail to rein deficits in as much as the EC expects, there will be more competition for demand. The ECB will also have a key role to play in absorbing this new supply if it boosts its APP purchases next year.