(ING Global Economics Team)
This week’s charge higher by central banks is led by the Fed. A hawkish 75bp hike should leave markets bracing for more to come, curve flattenig included. European Central Bank officials are also signalling increased preparedness to hike even in the face of a downturn.
Fed leads this week’s central bank charge towards higher rates
Upward pressure on rates remains intact with 10Y UST yields briefly punching through 3.5% and German 10Y bund yields continuing to flirt with 1.8%. But it is clearly the front end of curves that feel the pain of central banks continuing to pull in the reins. This week sees several central banks across the globe expected to hike rates, with the Federal Reserve and Bank of England clearly taking centre stage among them. The Bank of Japan later in the week is likely to be the exception, resisting a shift of policy.
For the Fed meeting on Wednesday night the market is discounting a 20% chance of a 100bp hike. Indeed, our economists don’t think the Fed will opt for a jumbo hike but stick to 75bp, but more important will be what the bank signals as further trajectory ahead. If the Fed moves its dots higher, markets’ anticipation of further hikes should move up alongside pricing in more firmly rate increases of similar magnitude. Current market expectations have the Fed’s 2.25-2.50% target range moving to 4.0-4.25%, if not above by year-end. As long as we are on that upward leg also long-end rates can remain dragged higher in the slipstream of front-end rates, though the curve is likely to invert further in the process.
10Y Treasuries are caught in the slipstream of higher front-end rates
ECB officials keep pushing the hawkish message – and curves flatter
Curve flattening also remains a theme for EUR curves, where ECB officials continue to drive home their hawkish message in unprecedented unison. The 2s10s swap curve has also inverted since the end of last week, and the Bund curve has dipped below 20bp. The hawkish rhetoric by ECB official should help this dynamic even as PMIs later this week could send more warning signs about the economy.
Over the weekend Chief Economist Lane had signalled several more hikes, the added nuance now being that this might even happen in the face of a mild recession. Markets have been used to the Bundesbank’s Nagel calling for rates to move a lot higher from here to control inflation, but also the Bundesbank sees increasing signs of recession even if worst-case scenarios can be avoided. Underscoring the ECB’s new determination, the Vice President made clear that the economic slowdown by itself will not be enough to bring down inflation; monetary policy will need to do its job as well.
As the ECB keeps pushing the rate hike discount higher – market pricing implies expectations of the deposit facility rate reaching at least 2.5% by the end of the first quarter next year – it has to be mindful that sovereign spreads could become collateral damage. Despite the upcoming general elections in Italy this weekend Italian spreads over Bunds have traded relatively well-behaved. The signalling on quantitative tightening has been vague until now but could already pick up in earnest starting in October. This will be the key test for the ECB’s currently successful efforts to keep spread volatility in check, even if ultimately a further widening cannot be avoided.