Rates Spark: Make up your mind

It is hard to disentangle all the drivers of the bond market. Yesterday witnessed a strong performance led by a bull flattening of the EUR curve. Perhaps it was that the EU supply has been digested, and some of the strength may be due to month-end extensions. If the latter were the case, we could see some pullback today, especially with the Spanish and French supply looming early in the session.

However, the spread of the Delta variant has also put a dampener on market sentiment as it puts the faster reopening trajectories at risk. Eurozone economic sentiment rising to the second highest on record yesterday has been flatly ignored by markets.

A sense of risk-off does not necessarily mean wider eurozone government bond spreads. Here markets should rather be eyeing the reaction function of central banks. In the case of the ECB the barrage of dovish comments suggests that an extension of current support measures would only get more likely should we see a further deterioration of reopening prospects. Not too long ago the market seemed almost fully subscribed to the ECB’s current plans to end the net purchase phase of the pandemic emergency purchase programme (PEPP) by the end of 1Q next year – that is judged by the June survey of monetary analysts.

This leaves room to for markets to price in more prolonged support, or at least somthing that will cushion the end of net PEPP such as higher volumes via the traditional asset purchase programmes (APP). A direct beneficiary would be the Italian bond market. In the 10Y space we have already seen a retightening of spreads over Bunds by c.5bp over the past few days with a push yesterday. But then – speaking of disentangling – we also had Italian bond auctions with decent demand yesterday.

USD rates traded comparatively calmer yesterday. One reason is perhaps that the market still has to fully make up its mind of how to judge the Fed's new reaction function follwing the hawkish surprise at the last Fed meeting and the subsequent communication. The upcoming key data releases could provide more clarity before we go into the summer. The case for the US front-end to price in chances for earlier Fed interest rate hikes appears clear, how the long end should react is less clear cut.

A firm ISM manufacturing today should be a given, but the greater focus will be on the supply bottlenecks that could indicate more price pressures. The Fed's Kaplan acknowledged that the US is seeing "broadening price pressures rippling into a broader range of items". He has been a proponent of scaling back the Fed's bond purchases rather sooner than later, especially as these cannot address the current supply problems. Of course the doves will note that the job market is still far from its pre-pandemic performance, but also here tomorrow's data could provide a bit more clarity on where the issues lie, especially if higher wages indicate demand for workers not being the problem.