Rates Spark: Migrating doves

It's not been an easy market to read of late. Navigation of uncertain geopolitics and extreme macro circumstances has made it ultra tough.

What we can see from the latest weekly flows data (through to the close on Wednesday) is an inflow to government bonds, and especially into front end product. There is certainly more value on front ends with all this rate hike talk going on, but part of this also reflects some parking of cash and de-risking as the Russia-Ukraine stand-off continues

Flow reflect some parking of cash and de-risking as the Russia-Ukraine stand-off continues.

There is also evidence of re-risking in other asset classes, as there have been more outflows from investment grade corporates, and the bulk of these outflows are from longer duration product. High yield too has seen outflows, and the largest in proportional terms is out of EUR-denominated high yield. Emerging markets too have seen outflows, and this time including dedicated local currency outflows. Not an avalanche, but enough to be classed as a trickle that's persistent enough to worry about.

Some of the macro story can be gleaned from inflation-linked funds, which also saw more outflows. Assets under management in inflation-linked product are down some 3% in the past month, helping to ease real rates higher. The only reason that real rates are not higher than they currently are is the fear factor that is Russia - Ukraine, and the quality flight that could emerge should things turn sour.

Actively selling MBS is an alternate and material Fed tightening channel

The Fed’s Bullard only yesterday reiterated his view that rates needed to be 100bp higher by mid-year to curb inflation. He occupies the very hawkish end of the FOMC spectrum, but market forwards are not too far off. They have SOFR in July at around 0.96%, i.e. 90bp higher from current levels, and maybe that is already too steep, hawkish comments notwithstanding. If the idea of actively selling MBS from its portfolio gains further traction within the FOMC, then this is an alternate and material tightening channel that can further take the steam out of front end rates.

Although we have seen levels come off the boil already, the aggressive pricing of policy tightening across the developed market space should remain in focus in the coming week. In the UK the Treasury select committee will quiz the BoE on inflation, and it could offer the Bank’s governor another platform to push back against aggressive market pricing. So far reiterations that “modest” further tightening would be needed have not restrained hike speculation in any meaningful way.

Official pushback against the pricing of two hikes already this year has been timid

Eurozone front end rates may look equally stretched, though the difference here is that official pushback against the pricing of two hikes already this year has been timid. We find it noteworthy that the ECB’s Chief Economist and arch-dove Philip Lane passed on an opportunity to offer a more forceful verbal intervention yesterday, and instead retreated to a typical two-handed economist’s description of the policy options. Spain’s De Cos at least argued one should take the fragmentation of markets into consideration, a clearer acknowledgement of the rising sovereign bond spreads of late, and called for a gradual removal of accommodation.

Markets may get a better picture of the discussion behind the ECB’s hawkish turnaround at the last press conference when the minutes of said meeting are published next week. But we doubt this will make the policy path much clearer with many officials having indicated that even the March meeting may well provide only a monthly guidance.

The ECB’s desire to keep all its policy options open will still have the market looking to the data for more guidance. In that regard next week will offer the PMIs which could show some improvements as governments have eased restrictions, and perhaps more importantly first country inflation updates out of France at the end of the week.