Articles
16 November 2021

Rates spark: Mr Whippy

There is no let-up in rates whipping around this week, with GBP and CAD rates in the driving seat. Risk sentiment is at risk of worsening into year end as Covid-19 cases build. This means a flatter curve, all else being equal. That said, many core curve should be steeper, as inflation risks remain as yet unchecked by policy. 

Curves should be steeper, but are being curbed by demand

With the US curve still trading 100s of basis points below headline inflation, it's hard to reconcile why long-end rates are not running more scared of inflation risks. This is especially so as central banks, like the Fed, ECB and BoE, have yet to stand in the way of a medium-term inflation issue. That is not to suggest that this policy stance is wrong, as the manufacture of inflation has been tough to pull off in the past decade or so. But that does not mean that long ends should be so relaxed.

Long ends have received a lot of support from the buy side in recent weeks.

Part of the answer comes from long ends receiving a lot of support from the buy side in recent weeks. Last week saw further inflows into long end government funds, and since the 10yr hit 1.7% a month or so ago, there has been corporate receivers and asset manager buying in play. The former is based off a techncial fixed float preference, and large positive carry from receivers. But the latter, asset managers, are just locking in negative long term real returns.

Higher inflation hasn't dampened demand for long-dated rates products

Source: Refinitiv, ING
Refinitiv, ING

This should not continue, and indeed some ropy US auctions last week saw the beginnings of a buyers strike

This should not continue, and indeed some ropy US auctions last week (especially the 30yr) saw the beginnings of a buyers strike that has taken the 10yr yield back up to the 1.6's %. Within spitting distance now of 1.7%, there should be an edge towards that ahead. That should steepen the curve for as long as the Fed is holding pat and not showing any signs of panic.

A hawkish tilt, and or a flight to safety (see below), are factors that point more towards flattening, albeit different types of flattening. The one from the front end is more likely in a structural sense, as we will get there at some point with a degree of certainty, as the Fed ultimately hikes. And that would pitch the curve above where it is now. The second type of flattening is a more tactical risk, partly centred on the vagaries of risk assets.

A worsening in risk sentiment would add to curve flattening

It is hard to escape the daily reality of markets’ inflation concerns but, increasingly, other factors are dampening its impact in some places, most obviously long-end interest rates.

The most obvious risk to risk sentiment in the near-term is the resurgence in Covid-19 cases, and associated restrictions, across much of Europe. It is too early to make a call on economic implications but the hope is that states have learned to impose health measures in a way that is the least disruptive to activity. This being said, a protracted Covid-19 wave would at least compound fears of supply bottlenecks and of a longer-lasting spike in inflation.

A protracted Covid-19 wave would compound fears of a longer-lasting spike in inflation

The other likely impact is greater demand for safe assets. In the rates world, this means flatter curves all else being equal. This is because we expect long-end bonds to gather more of that safe-haven demand. The other reason is that central banks have been at pains to explain that transitory nature of inflation, and how the current spike is linked to the pandemic. Yet a new wave would likely raise inflation expectations further, and keep upward pressure on front-end rates.

The ECB eases the EUR collateral crunch

Safe haven demand can also delay convergence of government bond yields relative to swap rates too. A number of factors have contributed to a breakdown in correlation between the two, in particular at the front-end. Some of these factors are seasonal, such as the demand for safe collateral into year-end. The ECB took a decisive step yesterday to ease this collateral crunch by raising the amount of cash market counterparties can pledge to national central banks (NCBs) in exchange for securities held on their balance sheets. The overall limit was doubled to €150bn spread across the Eurozone's NCBs.

Short-end swap spreads tighten as the ECB releases more collateral

Source: Refinitiv, ING
Refinitiv, ING

The ECB took a decisive step yesterday to ease the collateral crunch

A worsening in risk sentiment would contribute to wider swap spreads still (lower bond yields than matched-maturity swaps rates), or at least delay their re-tightening once year-end distortions fade. The ECB's measures have mostly been felt at the front-end of the swap spread curve so far,.where we would expect the impact of the collateral shortage to be the most acute. Longer tenors should prove stickier in our view, as they also reflect the growing number of risks, including that of an abrupt tightening of monetary policy.

Today’s events and market view

Today’s economic highlights include US retail sales and industrial production. Our economics team expects decent outcomes on both releases. Another important data point will be the NAHB housing index, with pressure on the housing market being an important factor in the rise of US inflation. Taken together, we think they will keep the pressure on short-dated US rates.

The Eurozone’s Q3 QDP will be slightly more dated but no less interesting. There is a clear risk of a slowdown into Q4 and Covid-19 case resurgence is clouding the outlook further.

On the central bank front, ECB president Christine Lagarde and a raft of Fed speakers are all scheduled to make appearances.

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