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Getting into Position for a Decisive Week
Summary:
Featuring U.S. CPI data, three major central bank meetings - if one adds the Bank of Japan - and substantial bond supply, next week should shape up to be a decisive one for rates markets.
Central banks to decide against backdrop of still high inflation but heightened macro uncertainty
Markets are bracing for a decisive week which sees central bank decisions from both the Federal Reserve and the European Central Bank. The backdrop of late has been one of heightened macro uncertainty, but with inflation still running uncomfortably high.
Especially in the U.S., ambiguous signals from the jobs market have jolted rates markets around. Following a very strong payrolls number, we have now seen yesterday what could be the first signs of lay-offs feeding through to the weekly jobless claims data. In the eurozone, final 1Q GDP data has now confirmed that the economy was in a (shallow) technical recession, while prospects for a notable uptick in the second quarter are dim. At the same time, the jobs market here remains resilient and inflation is still painfully slow in turning lower.
As central banks' usual modelling has proven of limited use in the post-pandemic and geopolitical crisis-ridden world, they have become increasingly reliant on current data to guide their policies. Next week, that will mean an increased focus on Tuesday's U.S. CPI data just a day before the FOMC meeting. A core rate printing above the 0.4% month-on-month rate that the consensus is currently expecting could well swing the market back towards pricing in a hike. Note that in the week we will get more indications about pipeline price pressures from producer prices as well as import prices. And at the end of the week looms the University of Michigan's consumer survey including inflation expectations.
Market pricing and our views for next week's meetings
For the Fed, the market is currently pricing a less than 30% chance for a hike on Wednesday next week, but it is seeing an 80% chance of a 25bp hike in July. Our house view is that the Fed is already at its peak policy rate, though with the caveat that a higher CPI reading could still eke out a hike next week. In any case, the Fed is likely to leave the door open to more, and in a hawkish no-hike scenario this could be reflected in the dot plots, the FOMC members' projections of the Fed funds rate.
In EUR money markets the pricing of the policy path looks pretty much aligned with the ECB's own communication. A hike is a done deal for next Thursday and followed by at least one more in the following two meetings in July and September. This is largely in line with our economists' prediction which sees two consecutive hikes as the base case.
To evaluate central banks' effective policy stances one can also revert to OIS real rates. At levels closer again to the top of recent ranges, these suggest relatively tight policy circumstances, especially judged against the backdrop of the more mixed macro signals of late. This should give policy makers some comfort with regards to the reception of their recent communication, where the "skip"-narrative, bolstered by the Bank of Canada's example certainly has helped to curb a more pronounced pricing of cuts further down the line.
Supply can add a bearish tilt especially early in the week
The U.S. treasury will issue US$40bn 3Y and US$32bn 10Y bonds on Monday followed by a US$18bn 30Y bond sale on Tuesday. The setup around the CPI release and ahead of the FOMC meeting may warrant extra price concessions from dealers to absorb the duration risk. At the least, this could inject some extra volatility into the market.
Primary market activity will also remain elevated on the eurozone sovereign side. While it was syndicated deals pushing issuance volume higher this week, next week's scheduled auction supply could already push volumes closer to €40bn - we will see Italy, Germany, Finland, the Netherlands as well as France and Spain all being active with bond sales.
Today's events and market view
Today's session is light on data which suggests some prepositioning into next week's events. In U.S. markets also with a view to Monday's and Tuesday's Treasury supply. Data remains crucial, both for market and central banks as it increasingly guides their policies. While it was the jobless claims data that triggered a more noticeable retracement of yields, their levels closer to the upper end of recent ranges still signal a preoccupation with concerns around stickier inflation - Tuesday's U.S. CPI release looms large.
While we see only a limited ability of the ECB to move especially longer rates higher, while the skip narrative that has been pushed by the Fed and exemplified by the BoC should also prevent markets from prematurely jumping onto hopes that the Fed could be done. A Fed surprise hike could have more of an impact and invert curves as it further plays into the fears that more tightening could be needed to rein in inflation.
Source: ING
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