Rates Spark: When it rains it pours

Recession fears are taking over following a string of US data disappointments that extended yesterday with a low ADP payrolls estimate and more importantly an ISM services printing its lowest value since July 2020. The employment component of the index also dropped more than expected from 54 to 51.3, raising concerns ahead of the official jobs report due on tomorrow.

Markets are focussed on what lies beyond the peak of the current hiking cycle

10Y UST yields have dipped below 3.3%. But the extent of the initial market reaction especially at the front end, peak-to-bottom a drop of 25bp in the 2Y US Treasury yield before some of the gains were later pared, highlights a market that is increasingly focussed on what lies beyond the peak of the current hiking cycle. At the moment the market is looking for the Fed to cut rates by at least 75bp from their peak before the year is out.

The banking turmoil has added a large downside risk to the economic outlook, crucially with lagged data impact. That in mind we suspect that upside surprises would not have seen a symmetric move in yields, and that presumption likely holds ahead of Friday’s payrolls report. Anything above 200k in non-farm payrolls growth is likely to raise the chances for a final Fed hike in May, but markets will be cautious in extrapolating any data strength beyond that.

In the week after Easter the Fed will receive one more key data input: The month-on-month core CPI rate for March is seen decelerating to 0.4%, the year-on-year rate still inching up slightly to 5.6%. Both likely still too high for the taste of the Fed, but then the growing risks for a hard landing of the economy also raise the chance of inflation coming down more quickly going forward. The Federal Open Market Committee minutes of the 22 March meeting may give insight on the Fed's already shifting assessment of the economic backdrop as it came across more dovish at that meeting than expected.

EUR rates are in the passenger seat of US dynamics. The narrative that the end of the cycle is near is catching on, leaving markets open to ponder what lies beyond here as well. Croatia’s Vujcic was the latest European Central Bank member to highlight that the biggest part of the rate hiking cycle was now behind. As ECB chief economist Lane has laid out in a recent speech, the central bank sees itself on the right track with inflation dynamics to turn for the better soon. Pipeline inflation pressures are close to peaking and there are no signs of wage-price spiral – everything in the base case of course.

that the ECB is close to its peak, too, should not stand in the way for further convergence

However, the notion that the ECB is close to its peak should not stand in the way for further convergence of USD and EUR rates. Keep in in mind that the projections of the ECB are predicated on policy rates still moving a little higher and more importantly remaining there for a while. Banking system stresses, which have become a growing concern in the US and have pushed markets towards focussing on Fed rate cuts, are less prevalent in the eurozone.

EUR rates are still being dragged lower, but especially at the more policy sensitive front end, levels are holding up better. This has resulted in a further convergence of 2Y UST Bund spread, which briefly dipped to a low of 116bp yesterday, the lowest since late 2021.