Rates Spark: Reality check
How far can the gloom implied in interest markets stray from economic developments? This week’s raft of US data will help answer that question. We think the BoE will refrain from falling into a hawkish trap, with curve steepening implications
Europe: all eyes on the BoE
By and large the manufacturing and services surveys released out of Europe this week are a second reading and should play only a secondary role in shaping price action in rates. It is much more likely in our view that US rates will be in the driving seat this week, although long-dated supply from France and Spain could register after the aggressive curve flattening seen in the past month.
There is no need for the BoE to send hawkish signals given what the Sonia curve is pricing
Instead, the main event risk out of Europe this week is the BoE meeting, which comes with a new monetary policy report and press conference. Despite hawkish soundbites by some MPC members in recent weeks, we expect official communication to steer clear of dropping such heavy policy hints. Hikes remain a possibility earlier than our early-2023 timeframe but the uncertainty relating to the recent spike in Covid-19 cases, to name only one factor, argue for a more circumspect approach, in our view.
No policy error trade in sterling this week
This lack of follow up on hawkish comments is likely to catch rates markets in an overstretched position, in our view. Unlike its EUR and USD peers, the GBP curve continued flattening in the second half of July, pricing something akin to the policy error trade that followed the hawkish June FOMC meeting, saw the curve flatten aggressively and price out hikes (the Fed has since adopted a more balanced tone allowing the US curve to regain its composure).
The GBP curve flattening has reached stretched levels due to hawkish soundbites
This overstretched flattening, and the possibility of further hints on the BoE balance sheet unwind strategy, puts the back end of the curve at risk of steepening. As a reminder, ever since Governor Andrew Bailey has argued in favour of starting the balance sheet unwind earlier in the tightening cycle than previously envisioned, we find that the risk of a snapback is significant.
Today’s events and market view
There is a barrage of manufacturing sentiment surveys released today but most of the European ones, save for Spain’s and Italy’s, will be second readings. On first release, they showed confidence remained high even in the face of another wave of Covid-19 in some parts of the Continent. Judging by Bloomberg consensus, the same is expected from Italy and Spain today.
Their US equivalent, the ISM manufacturing, will be released later in the day. This index has not displayed the same degree of gloom that rates markets are currently displaying in the face of higher inflation. The two can diverge for some time, but another elevated print would be hard to ignore with real rates at record lows. Construction spending will conclude the series of releases today.
The session will be peppered with a series of bill auctions from the likes of France, Germany, and the Netherlands.
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