Rates Spark: Pressure points

This is a bond market that has chosen to ignore inflation worries, but can't ignore macro reality completely. Friday's payrolls report kicked off an upward test in yields, and so far the net surround music has pushed in the same direction. The approach of tapering, and likely a quick version of it, is really all about achieving the substantial progress that the Fed has been talking about in previous quarters, and that is really centred on the labour market. Delta variant or not, we are getting there in something of a relentless manner.

Meanwhile, the volume going back to the Fed on the reverse repo facility rose again, to US$980bn. Given the debt ceiling cap on bills issuance plus a Treasury spending down cash it holds at the Fed, the net effect is higher reserves and less available collateral. This will place renewed downward pressure on bills rates, and will likely see the volume of cash going back to the Fed at 5bp push structurally above US$1trn in the coming weeks. A suspension or elevation of the debt ceiling is required to help avert this, but a quicker taper would also push in the same direction.

If one is looking for a culprit for the failed attempt to turn lower in yields so far this week, the sharp decline in oil prices is a good place to start. Relationships between asset classes varies over time but it is noteworthy that the correlation between bond yields and Oil is on the rise, and sends a coherent macro signal that should be listened to. On the face of it, the chief worry for Oil seems to be the drastic measures taken to stop the spread of Covid-19 in China. We suspect bonds normally have a more domestic focus, owing to the heavy hand central banks have in setting local interest rates. Nevertheless, the size of China’s economy and its contribution to global growth argue in favour of giving further attention to the signal sent by Oil.

Correlation between bond yields and Oil is on the rise, and sends a coherent macro signal that should be listened to

The local focus in government bonds on the other hand, is confirmed so far this week by the reaction to higher-than-expected US job openings. In addition to the confirmation that the job market is on the mend, further rises in yields emerged when Raphael Bostic added his voice to the chorus of hawkish officials. Not only did the Atlanta Fed’s president express his preference for hikes to starts in 2022, he added that he would only need to see one or two more job reports like July to vote in favour of tapering.

If both factors undid the bond rally, they didn’t translate into significant curve movements. It could well be that appetite to add new curve positions ahead of the all-important US CPI report later this week is limited. It could also be that the approaching prospect of tapering within a few months is focusing the minds a little more than the ‘talking about talking about tapering’ mantra repeated so far by the Fed in its official communication. So far, the curve remains in a clear flattening dynamic, but we look out for signs that tapering fears are starting to resonate with the long-end.