Spark of the rates: the untimely Italian jitters for the ECB
(MENAFN-ING) US Pipeline Inflation Pressure Reaches 11%, But Expectations and Hearts Relax
We got a handful of 11% on headline US PPI inflation yesterday, but core inflation is down, as was in fact the core CPI the previous day. The market’s reaction was that inflation expectations eased further. The 2-year break-even point is now approaching 2.9%. It was 4.5% a month ago! The 10-year break-even point is approaching 2.3%, and also down slightly after the PPI. Most of these arguments are in favor of keeping the Fed with a 75 basis point hike, not a 100 basis point exit.
The curve structure also shows separation from a 100 basis point upside. The reversal on the 2/5 year segment intensified after yesterday’s CPI, suggesting that longer term market rates are not being pushed higher by this; which is logical since inflation expectations are falling.
The 2/5 year reversal also holds at the PPI number, as does the 5 year outright wealth move towards the curve (albeit slight). No fireworks after this number so far. But there is a separation between the money market discount approaching a 100bp hike and the bond market discount on the curve that argues more for a steady 75bp hike.
Either way, all this price action continues to argue that the peak in market rates has arrived, with the reversal (particularly on the 2/5yr) suggesting that an acceleration in the upsides is not actually not the way to go.
EUR rates show higher volatility than their US counterpart
Will the EUR curve follow in the footsteps of the UST?
During yesterday’s rate sell-off episode, Bunds actually underperformed US Treasuries. This makes sense considering that it is the European Central Bank that has to catch up in its fight to contain inflation. At the same time, we believe that the Eurozone is more exposed to recession risks, which should limit the relative increase in long-term yields. But with Euro rates proving to be more volatile than their US counterparts, we suspect that low market liquidity is helping to amplify current market moves.
As the bearish curve flattens, the front end is pricing in a growing likelihood of a more than 25bps hike from the ECB next week . Some 35 basis points were valued at points yesterday, some 165 basis points in total at the end of the year. The forward curve does not show a bump shape, ie there are no expectations of a rapid pace of tightening followed by rate cuts.
However, we believe it is premature to call on the Euro curve to follow the lead of the US curve towards a bearish structural flattening. For us, this would also require the ECB to actually respond to market expectations for rapid policy tightening. We doubt that the ECB will be able to ride out as aggressive an upward cycle as expected with the rapid closing of the economic window of opportunity.
Markets expect a rapid rate of tightening for the ECB
Italian political stage fright at the worst possible moment for the ECB
The widening of the BTP/Bund spread was one of the most salient market moves in the euro rate space. The 10-year spread was trading close to 20bp at times and is again well above 200bp, i.e. in the 200-250bp “danger zone” that prompted interventions verbal comments from the ECB in the past. In the run-up to the ECB meeting next week, this also brings the topic of the anti-fragmentation tool back to the fore. It is not just the timing that is unfortunate for the ECB, but also the nature of the latest spread widening, rooted in the current political crisis in Rome.
The ECB is expected to give more details on its new tool with which it aims to fight against the unjustified widening of sovereign spreads. However, one can hardly speak of an unwarranted broadening of the current political situation, which could tie the hands of the ECB at this stage. To make matters worse, stating too strict conditionalities of the new program could worsen an already fragile situation. But so does staying more reserved on the key details facing a market that ideally yearns for another “whatever it takes” from the central bank.
Although this may not be the end of the Italian unity government yet, it will probably only be decided in the coming week. Either way, political confidence will be shaken and, for now, the possibility of a snap election in the fall still looms large.
Political uncertainty increases pressure on Italian bonds
Today’s Events and Market Views
US rates should be in the driver’s seat as markets gauge the magnitude of the Fed’s next move(s) and today’s data provides some of the remaining pieces of the puzzle. The University of Michigan Consumer Confidence Index recently fell to an all-time low, but the inflation expectations series should be watched more closely. Its peak last month was seen by many as the trigger for the Fed to signal it would hike 75 basis points in June.
The Fed’s Bostic and Bullard are due to speak on the economic outlook and monetary policy.
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