Rates: Why core market rates may rise

Inflows into risk assets have been impressive since the beginning of the year, in stark contrast to the dramatic selling of risk assets seen into end-2018. That risk asset selling coincided with an equally dramatic fall in the US 10yr yield from 3.25% to 2.5%. And while risk assets have since rallied off those lows, the US 10yr yield has not managed to budge much from the 2.5% area.

The US 10yr in the 2.5% area is remarkably steady given the strong inflow to risk assets

Some dodgy US economic data justified a medium-term Fed rate cut preference through Q1, in turn keeping market rates under wraps. But since then, US data has perked up. The fall in the 30yr mortgage rate that coincided with the fall in Treasury yields has also managed to stabilise angst that has been growing in the housing market. But still, the 10yr Treasury has held in the 2.5% area.

The balance of risks ahead are slowly swinging in the direction of a test higher for market rates. The basic assumptions here are an ongoing inflows process to risk assets and a positive gloss on macro data. The off-setting pull lower in rates comes from the ongoing global slowdown narrative, weakness in Europe, and an ongoing stubbornness with respect to the regeneration of inflation generally.

The latter remains a massive issue in the determination of exceptionally low markets rates in Europe. But as we have noted before, low German rates are also reflective of a safe haven status against a backdrop where Italian government bonds have struggled with Italian political and macro concerns. Such concerns will linger right through to the end-May EU elections at the very least.

It is circular though, as the German 10yr yield at zero is also being pushed there by the US 10yr Treasury yield falling to the 2.5% area, to yield a 250bp Treasury/Bund spread. While the mean of this spread is around 50bp in the past 3 decades, rationalising a fair value spread in the 250bp area is not difficult based off a fed funds rate at 2.5% versus an ECB deposit rate of -40bp. Bund yields at zero partly reflect Treasuries at 2.5%.

The cleanest way for European rates to rise from here would be for US rates to show them the way, most likely being pushed higher by some firm labour market data. Right now the slowdown narrative is dominating the market discount. But this cannot continue if risk assets maintain the buying interest seen so far this year. The buying of risk assets by definition shows confidence in future growth and tolerable default risk.

European rates need US rates to do the heavy lifting first

One of the best performances so far this year has been from high yield corporates. This is a high beta sector and is expected to outperform in a market that is seeing spreads narrow. But is it also re-assuring for growth continuation, as it implies a benign implied market discount for recession. The rationale here is if a recession was imminent, corporate high yield would run scared on account of higher default risk.

The yield curve inversion narrative has also been curbed. Not only has the 10/30yr held on a respectable steepness, but the 2/10yr has re-steepened, and the inversion on the 2/5yr has almost disappeared. All this implies that a rate cut from the Fed is still quite a way off. If the Fed does anything in the coming year it is more likely to be a hike than a cut, and this risk is not being discounted. Market rates should begin to build that risk into current valuations, which implies some underlying upward pressure.

This article forms part of our Monthly Economic Update. See the full report here