Bond Traders Weekly Outlook: Europe, Over Tightening with Recession Fears

U.S. Treasuries saw strength in the shorter tenors reflecting a manifestation of inflation related Fed overtightening and forced recession fears. Europe, particularly Italy, is unnerving credit markets which is also giving treasuries a bid. Treasury yields declined this week in the face of a surge in European yields. For the week, two-year Treasury yields dropped a sizable 17 basis points to a more than two-month low 4.18% (down from Nov. 7 high of 4.72%). and the 10-yr note yield fell nine basis points to 3.48%.  The bond market focus has shifted towards fundamental developments and away from monetary policy. The S&P 500 fell 5.0% from where it was just ahead of the FOMC decision on Wednesday to its closing level on Friday. 

Hungry Bond Traders

There is a firm belief the Central Banks are blindly raising rates because ‘they have to’ and the consequences will be dire, furthermore that the US Administration is bumbling along with damaging decisions one after the other. A Bloomberg headline is insightful, “Bond Traders Dismiss Fed’s Hawkish Tone, Bet on 2023 Rate Cuts.”

Weekly Recap

U.S. Treasuries were higher by weeks’ end. We had two major events the US CPI report and then the Central Banker Maelstrom of rising rates following the Fed on Wednesday. The November Consumer Price Index (CPI) came in tamer-than-expected on Tuesday. We had both a 10- and 30-year bond auction. Notable was the poor performance of the long bond despite the tamer CPI report.

The thought was by many that the moderation in headline inflation should convince the Fed to temper the pace of its rate hikes to a lower ceiling on its terminal rate. This was not to be as we saw from Powell Wednesday.

Powell in the Press conference: “Changing our inflation goal is not something we’re thinking about, and it’s something we’re not going to think about… I think this isn’t the time to be thinking about that. I mean, there may be a longer-term project at some point.”

When one looked deeper into the CPI the sticky, and elevated, core services number was a concern ahead of the FOMC, and helps explain the hawkish in the updated Summary of Economic Projections, and Fed Chair Powell’s press conference on Wednesday.  The median estimate for the terminal rate in 2023 had been raised to 5.10% versus the September projection of 4.60%.

Thursday’s session was dominated by a slate of rate hikes from other central banks. Following the Fed, a slew of banks raised.

Central Bank Collusion: Since yesterday’s Fed +50bps ECB +50bps Bank of England +50bps Swiss National Bank +50bps Banco de México +50bps Philippines +50bps Hong Kong Monetary Authority +50bps Norges Bank +25bps Taiwan +12.5%bps

ECB Chair Lagarde was fearsome in her dire warnings for the European economy following the ECB announcement. The market worried even more about the risk facing Europe with high energy costs, in Italy in particular.

Reuters: “Debt-Laden Italy Lashes Out at ‘Crazy’ ECB After Rate Hike.” Monetary union instability is here, if it ever left of course.

The result saw safe haven treasury bond buying. Treasury yields declined this week in the face of a surge in European yields. German bund yields jumped 22 bps to 2.15%, with the spread to Treasuries narrowing a notable 31 bps to a two-year low 135 bps. French 10-year yields jumped 28 bps (2.68%), Spanish yields 29 bps (3.25%), and Portuguese yields 31 bps (3.17%). Italian yields surged 46 bps (up 69bps in six sessions) to a six-week high 4.30%.

The Fed and ECB didn’t let up on Friday with further rate hike speculation remained alive as several policymakers from the European Central Bank waxed on about the need to continue raising rates while San Francisco Fed President (non-voter until 2024) Daly said that it would be reasonable to hold rates at a peak level for nearly a year and that she doesn’t understand why the market is optimistic about future inflation

The expected Fed funds rate at the FOMC’s March 16th meeting dropped 10 bps this week to a seven-week low 4.78%. The expected rate for the June 15th meeting fell 15 bps to a nine-week low 4.76% (December down 18bps to 4.35%).

Yield Watch

  • 2-yr: -5 bps to 4.20% (-14 bps for the week)
  • 3-yr: -5 bps to 3.90% (-17 bps for the week)
  • 5-yr: -1 bp to 3.62% (-14 bps for the week)
  • 10-yr: +3 bps to 3.48% (-9 bps for the week)
  • 30-yr: +4 bps to 3.53% (-2 bps for the week)
  • Investment-grade bond funds posted inflows of $177 million, while junk bond funds reported outflows of $313 million (from Lipper).
  • Total money market fund assets jumped $22.6bn to $4.741 TN – the high since June 2020. Total money funds were up $105bn, or 2.3%, y-o-y.
  • Total Commercial Paper fell $15.9bn to $1.302 TN – declining from the high since November 2009. CP was up $216bn, or 20%, over the past year.

Key Rates and Spreads

Rates

  • 10-year Treasury bonds 3.49%, down -0.10 w/w (1-yr range: 1.08-4.22) (12 year high)
  • Credit spread 1.92%, up +0.12 w/w (1-yr range: 1.65-4.31)
  • BAA corporate bond index 5.41%, up +0.02 w/w (1-yr range: 3.13-6.59) (10 year+ high)
  • 30-Year conventional mortgage rate 6.17%, down -0.15% w/w (1-yr range: 2.75-7.38) (new 20 year high)

Yield Curve

  • 10-year minus 2-year: -0.70%, up +0.15% w/w (1-yr range: -0.85 – 1.59) (new 40 year low)
  • 10-year minus 3-month: -0.82%, down -0.10% w/w (1-yr range: -0.82 – 2.04) (new low)
  • 2-year minus Fed funds: -0.14%, down -0.65% w/w
10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity (T10Y2Y)

10 Year Note Technical Analysis via KnovaWave

Key Bond Auctions

Highlights – Mortgage Market

  • Freddie Mac 30-year fixed mortgage rates fell 11 bps to a three-month low 6.17% (up 305bps y-o-y).
  • Fifteen-year rates dropped 16 bps to 5.52% (up 318bps).
  • Five-year hybrid ARM rates declined 11 bps to 5.36% (up 291bps).
  • Bankrate’s survey of jumbo mortgage borrowing costs had 30-year fixed rates down two bps to 6.61% (up 337bps).
Mortgage News Daily November 4, 2022

Global Bond Watch

“Government bond prices around the world are moving in tandem, reducing investors’ ability to diversify their portfolios and raising concerns of being blindsided by market gyrations. Correlations between currency-adjusted returns on the government debt of countries such as the U.S., Japan, the U.K. and Germany are at their highest level in at least seven years, data from MSCI showed, as central banks around the world ramp up their fight against inflation.”

October 10 – Reuters (Davide Barbuscia)

Highlights – European Bonds

  • Greek 10-year yields jumped 31 bps to 4.29% (up 297bps y-t-d).
  • Italian yields surged 46 bps to 4.30% (up 313bps).
  • Spain’s 10-year yields rose 29 bps to 3.25% (up 268bps).
  • German bund yields gained 22 bps to 2.15% (up 233bps).
  • French yields jumped 28 bps to 2.68% (up 248bps).
  • The French to German 10-year bond spread widened six to 53 bps.
  • U.K. 10-year gilt yields gained 15 bps to 3.33% (up 236bps).

Highlights – Asian Bonds

  • Japanese 10-year “JGB” yields were little changed at 0.26% (up 19bps y-t-d).

Inflation Matters

Inflation with Henry Kaufman

Kaufman is the legendary chief economist and head of bond market research at Salomon Brothers is someone who knows Inflation.  Henry Kaufman in an interview with Bloomberg’s Erik Schatzker Jan 14, 2022:

 “I don’t think this Federal Reserve and this leadership has the stamina to act decisively. They’ll act incrementally. In order to turn the market around to a more non-inflationary attitude, you have to shock the market. You can’t raise interest rates bit-by-bit.”

“The longer the Fed takes to tackle a high rate of inflation, the more inflationary psychology is embedded in the private sector — and the more it will have to shock the system.”

“‘It’s dangerous to use the word transitory,’ Kaufman said. ‘The minute you say transitory, it means you’re willing to tolerate some inflation.’ That, he said, undermines the Fed’s role of maintaining economic and financial stability to achieve ‘reasonable non-inflationary growth.’”

The rubber is meeting the road as the trifecta of rising interest rates, the Russian invasion of Ukraine and surging costs continues to weigh, this has been no surprise to us here and shouldn’t have been to the market and PTB. You can only play with fire for so long before you get scorched!

With all the redirection of blame at the Fed about inflation one has to understand it is a global phenomenon outside the Fed’s Control. With the war drums louder than ever the supply chain issues are out of control. The Federal Reserve is not in control of global energy and commodities prices.

Everything points to powerful inflationary dynamics and a Federal Reserve so far “behind the curve.”

Instability is pronounced, credit defaults are on track to rise in North America, Europe, Asia, and Australia, according to a survey by the International Association of Credit Portfolio Managers. The economic slump is likely to occur later this year or in 2023, according to the survey.

Highlights – Federal Reserve

  • Federal Reserve Credit was little changed last week at $8.547 TN.
  • Fed Credit was down $354bn from the June 22nd peak.
  • Over the past 170 weeks, Fed Credit expanded $4.820 TN, or 129%. Fed Credit inflated $5.736 Trillion, or 204%, over the past 527 weeks.
  • Fed holdings for foreign owners of Treasury, Agency Debt last week increased $1.8bn to $3.308 TN – off the low since June 2017.
  • “Custody holdings” were down $129bn, or 3.8%, y-o-y.

Federal Reserve Gives All Banks a Pass in Annual Bank Stress Test

The Federal Reserve released its annual bank stress test after the market last quarter. All 34 large banks tested remained well above their risk-based minimum capital requirements, and the Fed announced no restrictions relating to dividends and buybacks. With the dismal state of the economy through soaring inflation and record low consumer sentiment these tests were keenly watched. Banks suffered slightly more hypothetical losses in the 2022 severe test than last year, posting $612 billion in projected losses as capital ratios fell to 9.7%. Read More Here.


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