Rates Spark: Perceptual vigilance

US yields temporarily eyed the upside starting into the week, but that was quickly reversed with a bigger than expected moderation in the US Empire State index. Risk mood had been dampened since the dismal Michigan consumer sentiment reading last Friday, and weaker China data as well as the developments in Afghanistan have only added to the cautious sentiment since then.

It might look a bit like a case-selective perception by the market. Last week’s CPI data showing inflation levelling off likely instilled some confidence in UST longs. But brushed aside are the signs of broadening inflation pressures. Similarly, yesterday’s Empire index, beyond the drop in the headline, also saw inflation pressures continue to build with the highest prices-received index value in its 21 year history as our economists have pointed out. Prices-received expectations for six months ahead dipped modestly, but are still the second highest reading of all time.

Through that lens we will probably also have to eye today’s data, the US retail sales and industrial production releases, with reaction to disappointments potentially larger than to beats. That could leave the market with bias toward lower rates for now, even with more hints towards tapering possible out of the FOMC meeting minutes already tomorrow evening. Fed Chair Powell does speak already tonight, but an event with educators seems an unlikely occasion for flagging big policy shifts.

In Europe the first impulse was for rates to follow the US lower. EUR rates do enjoy a benign backdrop from the ECB’s new strategy that makes hikes seem like distant future and looks set to keep asset purchases in place for some time. But at levels in the 10Y Bund close to -0.5% the room to move lower is limited. In the end 10Y Bund yields moved back above 0.47%, underperforming USTs by more than 2bp and putting the 10Y spread at just below 172bp.

The ECB has kept the pace of (gross) asset purchases relatively high, considering Europe is in its holiday break. The €17.1bn purchased via PEPP over the past week compares to an average of c.€19bn in April through July. But looming from the end of August is also the prospect of supply activities picking up again. That alone will likely not be enough for EUR rates to keep pace with US rates should they start to rise again - the UST-Bund spread remains directional.