US Treasuries: reflation or stagflation?
Before diving into this week’s economic calendar, it is essential to contextualize the events of last week surrounding inflation. CPI numbers surprised on the upside, with the yearly figure rising to 4.2% versus 3.6% expected. While the market expected high yearly inflation numbers due to last year’s depressed readings, the real surprise came from the monthly data. April’s headline CPI came out at 0.8% versus 0.2% expected. The problem with this number is that while the yearly inflation figures are transitory, there is nothing to suggest that monthly data also are. Following last week’s CPI reading, Federal Reserve’s members didn’t sound too convincing regarding the transitory nature of inflation. Fed’s Clarida admitted he was surprised about the readings and Kaplan sounded concerned about supply-demand imbalances, which could ultimately feed to higher inflation.
As economic data continue to surprise, bond investors must keep focused. Indeed, the bond market doesn’t price over CPI data but on inflation expectations. Therefore, it is necessary to understand the market’s expectations to predict better the direction of US Treasury yields. Right now, the message that we are getting from inflation expectations is not comforting: it will be much higher. We had breakeven rates and USD zero-coupon inflation swap rising to an eight-year high in the past few weeks. However, last week’s most notable move was the 5-year, 5-year USD inflation swap rate, which spiked to the highest level since 2014.
More alarmingly, inflation expectations are telling us that we might be risking stagflation. Indeed real rates, which are calculated out of the difference between nominal Treasury yields and the breakeven rate, continue to be deeply negative at -90bps. Real rates are becoming the key metrics for recovery and asset performance. Indeed as we head towards a recovery, real rates should rise to get back into positive territory. However, suppose we don’t see that happening. In that case, it means that growth is lagging inflation expectations and that more troubles are ahead for riskier assets.
The reason why nominal yields are not going anywhere right now is that the market believes that the Fed will not rush to hike rates. This is why the 2-year US Treasury yields are anchored around 15bps since last year. Albeit 10-year US Treasury yields are more sensitive to inflation expectations, they keep trading flat since March. Yet, any change in sentiment could push nominal yields higher. This week we will be focusing on the FOMC minutes on Wednesday and look for any change in wording concerning inflation and stimulus. We want to understand whether there starts to be doubt regarding the transitory nature of inflation and if tapering begins to be contemplated. Any tapering fears could lead to a tantrum.
The 20-year US Treasury auction will also be important as any weakness in demand could provoke higher yields. Last week’s 10-year US Treasury auction received strong demand as it offered the highest yield since January 2020. However, the 30-year bond sale didn’t go that well, as the auction tailed by 2.2bps showing that investors remain afraid to take on a long duration. The Treasury reintroduced 20-year Treasuries last year after they were discontinued for 34 years.
Don’t forget to watch out for the Eurozone CPI numbers released ahead of the FOMC Minutes and the bond auction. A surprise in the euro area’s CPI could provoke a selloff in European sovereigns as well as US Treasuries.
Tapering fears and CPI numbers will push European yields higher. Italian BTPS are becoming more appetible by the day as they now provide the highest yield in the euro area.
Rising government bond yields in the Euro area remain a focus. Last week 10-year Bund yields broke above their resistance at -0.15% and the ascending wedge they have been trading in since February. Now yields are in a fast area, and they could rise fast to 0% or drop back down below -0.15%.
Following news this morning that the Hungarian central bank may hike rates before tapering asset purchases depending on June’s inflation report, yields in the European area are rising. It strengthens our belief that we will most likely see Bund yields soaring rather than dropping as central banks are preparing to tighten the economy, and CPI numbers might surprise on Wednesday.
The yearly CPI figures for the Eurozone aggregate are expected to come out at 1.6%, well below the ECB target. If they come out considerably higher and above 2%, they might renew a selloff within government bonds in the Eurozone and across the Atlantic.
The market is starting to fear that the ECB, too, might consider tapering the ECB’s PEPP scheme on June the 10th meeting. We believe that this is not likely to happen for the simple reason that the central bank will be reluctant to tighten financial conditions in the euro area. Also, if the ECB were doing so, it would harm countries from the periphery, which are also the ones most hit by the pandemic. Italian BTPS has been one of the largest beneficiaries of the PEPP program. If this support were to lack, Italian yields would move higher quite fast. In light of the selloff in Italian sovereigns this morning, we believe it will be more likely for the ECB to expand the PEPP rather than reducing it. Right now, 10-year BTPS are offering a higher yield than Greece, which debt is rated junk and held mainly by foreign investors. Therefore, we remain positive Italian government bonds as the higher their yield is, the better source of return they are compared to peers. One of the themes recurrent for private investors is where to park money as banks are starting to enforce negative interest rates on clients deposits. When looking at short term European sovereigns, Italian BTPS are the only sovereigns able to offer a positive yield starting from four years of maturity.
Monday, May the 16th
- China: NBS Press conference, Industrial Production, Retail Sales
- Italy: Consumer Price Index
- United States: NY Empire State Manufacturing Index, Fed’s Clarida Speech, 3- and 6-month Bill Auction
- United Kingdom: BoE’s Vlieghe Speech, BOE’s Haldane Speech
Tuesday, may the 17th
- Japan: Gross Domestic Product, RBA Meeting Minutes
- United Kingdom: Claimant Count Rate, Claimant Count Change, ILO Unemployment Rate, Average Earnings Including Bonus
- Eurozone: EcoFin Meeting, Gross Domestic Product, ECB’s President Lagarde Speech
- United States: Building Permits, Housing Starts Change
Wednesday, May the 18th
- Australia: Westpac Leading Index, Westpac Consumer Confidence, Wage Price Index
- Japan Industrial Production
- United Kingdom: Consumer Price Index, Retail Price Index, PPI Core Output, Consumer Price Index, Retail Price Index
- Eurozone: ECB’s Panetta Speech, EU Financial Stability Review, Consumer Price Index, ECB’s Lane Speech
- Germany: 10-year Bond Auction
- Canada:BoC Consumer Price Index
- United States: FOMC Minutes, 20-year Bond Auction
Thursday, May the 20th
- Japan: Adjusted Merchandise Trade Balance
- Australia: Consumer Inflation Expectations, Employment Change, Unemployment Rate
- China: PBoC Interest Rate Decision
- Germany: Producer Price Index
- Eurozone: ECB’s Lane Speech,Construction Output, ECB’s President Lagarde speech
- Spain: 3-, 5- and 10-year Bond Auction
- United States: Philadelphia Fed Manufacturing Survey, Initial Jobless Claims
Friday, May the 21st
- Australia: Commonwealth Bank Services PMI, Retail Sales
- United Kingdom: GfK Consumer Confidence, Retail Sales, Markit Manufacturing PMI, Markit Services PMI
- Japan: National CPI
- Eurozone: Eurogroup Meeting, Markit Manufacturing PMI, Markit Services PMI, Markit PMI Composite, Consumer Confidence
- France: Markit Manufacturing PMI, Markit Services PMI, Markit PMI Composite
- Germany: Markit Manufacturing PMI, Markit Services PMI, Markit PMI Composite
- United States: Markit Manufacturing PMI, Markit Services PMI, Markit PMI Composite