Rates Spark: On edge, but risk perception calms

Volatility and credit spreads are on a declining path again. Developments out of the Israel / Iran spat are seen as either contained or manageable, with none of the worst fears for a wider impact materialising, as least not as of yet. US Treasuries broadly discounted as such from the very outset, preferring to home in on the potential inflationary ramifications rather than engaging on a safety play. This can cut both ways, and can manifest into a 'quality' flight. But so far the market has not been minded to morph this into a flight to bonds. Rather its been marked as a higher inflation risk and thus negative for Treasuries. The return of risk-on fits the same mold.

Ahead, the 20yr auction on Wednesday will be watched, as it tailed badly last time. At the same time, last week's 10yr and 30yr auctions went super well. Flows in the past week show some shedding of duration as a theme, and that can be gleaned from latest price action that is proving to be more heavy than seen in previous weeks. It seems when there is nothing front and centre to worry about that yields tend to creep higher, at least until we get some poor data to help pull yields back down again. The data in the coming days is mostly second tier, but still impactful enough to assess investor sentiment on direction.

Wednesday also sees the FOMC outcome, and we'll have the latest TIC flows data which will add some color to the appetite, or more likely the lack of it, as we progressed through a difficult period for Treasuries up until the tariff pause announced on 9 April. We expect to see some evidence of selling, but we doubt it will be as dramatic as some have predicted.

The conflict in the Middle East is yet another line added to the already long list of uncertainties facing the eurozone. Whilst of itself the direct impact may be limited, the headlines do not help with the recovery of confidence measures. Tuesday will give us the June ZEW surveys from Germany and the broader eurozone, which hopefully shows better numbers than the months before. For the growth outlook of the eurozone to brighten up materially, we’d have to see a more widespread improvement in consumer and business confidence.

Getting a better outlook on the eurozone’s economic will need time and until then the upside potential for the back end of the swap curve will likely be limited. Higher oil prices are not good for the growth outlook either and thus the back end of the curve could find itself lower despite inflationary risks being on the rise. Iran’s constructive view on further nuclear talks with the US helped oil lower again, but we still expect more price volatility ahead. Whilst the market volatility may not break the 10Y swap rate away from its 2.4-2.6% trading range in the near term, it can delay a move higher which we still anticipate later this year.