Rates Spark: Range trading within a declining channel

The growing confidence that contagion risk among US regional banks is now manageable, combined with the (probably misplaced) hope that recent stress will have limited real economic impact, are a toxic cocktail for core bonds. This is the last week before the Fed’s pre-meeting quiet period and recent comments have done nothing to contradict the market’s growing conviction (over 90%) that at least one more 25bp hike will be delivered. We do not change our view that rates are on a downward path but we also reiterate that this adjustment will not be on a straight line. Realised and implied volatility remain elevated and the coming weeks and months will feel a lot like range-trading, but within a declining channel. At least until data takes a more decisive turn for the worse.

This is the last week before the Fed’s pre-meeting quiet period

If front-end bonds are the worse affected, the sell-off in longer-dated treasuries has also been significant. Both 2Y and 10Y yields are standing at or above their post-Silicon Valley Bank (SVB) failure’s highs. These levels should in theory act as a psychological barrier to further rises unless investors are happy to move on from the US regional banking crisis without materially changing their economic expectations. To us, this is a stretch. Access to credit was already showing signs of tightening even prior to SVB’s failure.

If the recent re-pricing higher in rates very much feels like it is US-led, we think euro rates actually have a better reason to rise. According to a Bloomberg survey, consensus among economists is that the European Central Bank will deliver three more 25bp hikes in this cycle, which also ties in with what the swap curve implies. One could of course point out that with only one more hike currently priced by the US curve this year, followed by two cuts, there is more room for US rates to rise in the near term as optimism rises. We agree, but think this wouldn’t be sustainable.

Consensus among economists is that the ECB will deliver three more 25bp hikes in this cycle

Fundamentally, the discount for more hikes in Europe is the result of the ECB’s later start to its hiking cycle, but also of still accelerating core inflation. Barring a drastic divergence between the two economies, to Europe’s disfavour, it makes much more sense for European markets to believe in the higher for longer narrative than in the US where rates are already twice what the Fed signals is the long-term neutral rate. Plentiful long-end supply probably aggravated the euro bond sell-off in recent days and we could see some stabilisation today. This means wider Treasury-Bund spreads before the tightening resumes.