Rates Spark: The side effect of weighing the scenarios

There was little in terms of data for markets to work on as we await tomorrow’s US CPI release.

Benign inflation outcomes have indeed been a main driver in terms of rate cut expectations, so sensitivity to the upcoming data looks likely. But we should also note that market pricing does not reflect an expected baseline scenario – which is still more about a soft landing – but rather a probability-weighted average outcome. And downside tail risks have been the key to lower market rates – think for instance of concerns around delinquencies in consumer loans or commercial real estate which could again send jitters through the US banking system, especially for smaller banks. The Federal Reserve's Michael Barr indicated last night that the emergency Bank Term Funding Program might not be expanded beyond its 11 March expiry date, which only adds to the uncertainty.

While these possible outcomes must be accounted for in pricing, it also means that market rates at current levels are probably too accommodative. A look at real interest rates also shows the 2Y US real OIS rate is still at its lowest level since early June. In the EUR space, real rates have been more range-bound, although longer tenors are closer to the bottom of last year’s range.

In the end, heightened uncertainty about the outlook manifesting itself in very inverted money market curves could have a bit of a self-fulfilling effect. If lower and more accommodative market rates persist, then central banks could be all the more tempted to keep key rates on hold for a little longer. Unless of course, a tail risk materialises in the meantime.