Relief Rally After The More Dovish-Than-Expected ECB Meeting

Lower rates volatility suits everyone

After Thursday’s more dovish-than-expected ECB , the relief rally in US and European equities is continuing in a more muted fashion in Asia. This week’s critical data and events – weaker-than-expected US and the ECB – inform that rising inflation expectations are not realizing yet. Some central banks – i.e. the ECB – will be more willing to lean against rising yields than others – i.e. the Fed.

This dynamic makes global yields bid, with Indonesia -6bp, New Zealand -8bp and Taiwan -10bp, outperforming in Asia. In this context, the backup in Korea’s government bond yields (KTBs) looks overdone around 30bp YTD.

Flows into equities should return in the near term given ‘s Tech-heavy sensitivity to higher global yields. The outperformance of the across FX today perhaps reflects this more docile rates theme.

However, the Mar. 16-17 FOMC is a significant test for the recent stabilization in global yields. Upbeat acceptance of higher yields could reignite a sell-off.

The Pre-Eminent Macro Question

The pre-eminent macro question for the United States in 2021 is: Will the medium-to-large burst of and economic activity baked practically in the cake for the next 6 months be durable or transitory? A quick spurt or a long boom?

I don’t think we can know yet, but there seems to be a very palatable gathering for risk markets as some UST  Bond Desk desk are forecasting UST yields coalescing around 1.75-1.8 % zone. 

Why there? First, it will be difficult for 5y5y OIS to move to the Fed’s terminal rate given the risk that a recession in the 5yr to 10yr window moves Fed Funds back to 0%. Second, while the US 1.9 trn stimulus means more supply, Bond traders think most of the adjustment will be bills and shorter coupons. So, while the number of dollars that needs to be borrowed will rise sharply, the increase in dollar duration (interest-rate risk) that the market needs to absorb will not increase meaningfully. 

So, if 1.75 % in 10 Y UST becomes the market base case, that not too bad rate risk situation at all for global markets

A more cynical view on yields

Let’s take a different view of the potential for rates. As I’m sure you’re aware, the yield curve has been steepening of late. The spread has widened recently from negative in August of 2019. In the past three recessions and recoveries, the curve has steepened to at least 2.5%. If the rate stays at current levels and the angle steepens to 2.5%, that implies a 10-year yield of roughly 2.65%. Is that going to happen? I have no idea, but I think it makes sense to see that as the potential even though there are significant differences between today’s steepening and past episodes.

Never assume what the Fed will do

The more significant point is that you shouldn’t assume you know what the Fed will do or the effect if they tried. Everyone should have learned over the last decade or so that even the Fed doesn’t know how their policies will impact the markets or the economy. Besides, as I’ve said many times, you don’t need to see the future as a profitable trader, but it would be best if you were quick to observe and analyze the present reasonably. 

Assuming that this steepening will be similar to the past three is probably reasonable – if far from certain – assumption.

Bonds entered this week very oversold, so to no one’s surprise, a near-term Bond rally unfolded since the  FOMC is still holding the SLR up their sleeve.

We know the trend for rates is up, and it probably isn’t over, but we don’t know precisely where that top yield is. And that is a very uncomfortable proposition for risk markets.

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