Rates Spark: All that negative talk

There is not much in the FOMC minutes to suggest that the Fed is considering negative rates, but that has not stopped the futures profile from continuing to discount them for chunks of 2021. It is just for a half a basis point or so, and not a structural discount. But at the same time it is there and won't go away easily, it seems.

There has been some discussion in the corporate sphere about potential implications from negative rates, with quotes for floors on swaps running at as high a cost as 10bp (as loans that they hedge typically have a floor at zero). And that against a backdrop where 3mth Libor is still some 37bp above zero. In any case all of this is consistent with the futures erring in the direction of discounting some element of a negative rates tail risk.

One way that the Fed could push the market away from such talk could be to raise the rate on excess reserves, in an effort to coax the effective rate (now at 5bp) away from the fed funds floor (zero). The FOMC minutes suggested that was not necesssary as the effective rate was not threatening to breach below the floor. While the Fed is not particularly fond of negatve rates, it seems it also does not want to completely rule them out.

We see this in the way the rates market trades too. The 2yr remains stubbornly below 20bp, and the 10yr is finding it tough to break above 70bp. The structure of the curve is also still consistent with low rates, as the belly remains rich to the wings. It is quite a contrast with the risk-on mode elsewhere.

Talk of negative interest rates is also prevelant in the UK. Despite insistence that a cut below zero is unlikely in the near term, Bailey’s refusal to rule them out has wrongly renewed focus on interest rates policy. Additional QE is far more likely in the near term and the curve reaction will be to bull-flatten. Not ruling out negative rates or any other easing measure in the medium term makes sense however, as the full downside for the economy is not yet known.

The DMO auctioned negative yielding debt, a 3Y Gilt, for the first time yesterday. We think this is as much a reflection of the shifting balance between supply and demand for government bonds, as it is of lower rate expectations. The BOE’s forceful intervention, and hopes of more purchases, means demand outstripped supply (see chart above).

Other rate curves, such as Libor and Sonia swaps, are still in positive territory. This may change, even if the probability of a cut below zero never rises above 50%: a worsening economic outlook would push some investors to pre-hedge a BOE cut, at least partially. This would push swap rates below zero, even before the BOE makes up its mind about it.

Spain is the last major EGB issuer to come to the market this week. We think the relief from this week’s supply slate being over in core and semi-core countries was already palpable yesterday. The coming three days should see reduced liquidity due to bank holidays across Europe and the US. Our best guess is that rates continue drifting lower from here.

Central bank comments continue unabated, and with them grow expectations of further easing. In the Eurozone, this should take the form of additional PEPP bond purchases judging from a Reuters survey of economists. In the UK, consensus has firmly shifted towards an increase in QE at the June meeting, as the BOE looks set to run out of firepower by early July.

Despite holidays in many countries the calendar remains busy. The preliminary PMI releases for April will grab the main attention from today's data releases. Expectations are for a decent rebound from record lows, especially in the service sectors. More businesses have reopened and therefore will be doing better, but the question really is by how much PMIs can recover as many restrictions are still in place.

In the US focus will remain on the initial claims data, which are proving to be stickier than hoped. Market expectations are for a decline towartds 2.4 million, but our economists stress even this would be a horrible figure, pointing to more social and economic pain for the country.

In primary markets Spain will reopen bonds from 3Y to 50Y maturities to raise €6-7bn. In Italy the sale of the BTP Italia will enter its second phase for institutional investors after already collecting orders of around €14bn from individual investors over the past three days. Supply activities will take a breather after today, but government funding will remain in the spotlight as new measures require new resources. The latest example is the Netherlands which has decided to extend its economic support packages by three months, a package worth €13bn.