Pricing Spark: Surfing the Perfect Storm


Despite a calm reaction to the Fed, the rise in bond yields resumes quickly – with a surprise rise from the Swiss National Bank, hawkish interpretations from the Bank of England and a fragmentation tool from the ECB likely to replace enlargement spreads through higher yields.

The Fed is in line with the market but the rate hike still dominates

For once, it’s not the Fed’s stance that is keeping bond investors awake. Admittedly, the pace of the hikes accelerated from 25bps in March to 50bps in May, to 75bps in June…but the Fed managed to warn investors, leading to moderate action prices around the meeting. Powell did not rule out a further 75 basis point hike but was quick to point out that this was not the new default increment. The Fed and financial markets now seem more aligned on both the path of rates and the economic outlook. Even if this means a greater risk of recession, it seems that the markets have been encouraged by the fact that the central bank is on the same wavelength as them.

This does not mean, however, that the rise in rates has diminished. On the one hand, the Fed has just shown that its policy trajectory will react to inflationary imprints and there is no guarantee that the series of bullish surprises will stop. 10-year Treasuries now have 3.5% in their sights, although they may wait for the next inflation release to test that level. Moreover, other central banks are not as advanced in their tightening process and the risk of hawkish surprises from various parts of the world means that yields will continue to rise.

Hawkish Surprises Keep Coming

The most recent example is the surprise 50 basis point hike by the Swiss National Bank (SNB), against consensus for no hike. Not only does the decision force markets to rethink the central bank’s reaction function, but it adds to the need for more aggressive action in other jurisdictions. Worse still, from the perspective of bondholders, the risk of currency intervention to defend the CHF means that the SNB could soon liquidate its portfolio of foreign bonds. We believe that EUR bonds are the most risky due to their low liquidity compared to their US peers. We have also identified the semi-core sector (eg France) as particularly vulnerable.

SNB currency sales would put USD and EUR bonds at risk (foreign exchange reserves at the end of the first quarter of 2022)

Source: SNB, ING

On the face of it, the Bank of England bucked the hawkish trend at its June meeting by increasing “just” 25 basis points. But the accompanying statement was more hawkish, actually opening the door to more aggressive tightening if needed, and enough for markets to conclude that acceleration is in the cards. At this point, we believe this is based on an assumption about future data that we are not ready to make, but at least the gilt sell-off after the meeting is consistent with how markets are more pricing in future policy in d ‘other countries.

According to its recent communication, markets are looking for an even steeper trajectory for BoE rates

Chart

Source: Refinitiv, ING

ECB spread management could contribute to higher yields

If that wasn’t enough to keep bond investors on their toes, public commentary on the ECB’s fragmentation instrument is on the rise. The most detailed (anonymous) indication to date came from a Bloomberg source, suggesting that the facility would sell core bonds to neutralize the effect on inflation of Italian bond purchases. In our view, this is a key limitation on the size of the ECB’s intervention, as adding bond sales in one of the worst bond market sales in recent years poses risks. for financial stability. This may be just one of many potential designs considered, but we believe that this constraint would decrease the effectiveness of the facility, making it more likely that the ECB would have to buy peripheral bonds, and therefore result in more purchases than necessary.

ECB sharding tool could trade wider spreads for higher yields

Chart

Source: Refinitiv, ING

There also seem to be competing visions of what this instrument would look like. Recent public comments have shown that there is a range of opinions on what the ECB’s intervention would look like. For example, Muller seems to favor a light approach while Visco has gone so far as to give a level in the 10-year Italy-Bund spread justified by fundamentals, and therefore as a potential target. The reality of the new instrument is likely to lie somewhere between these views, but they serve to illustrate, alongside the potential constraints discussed in the press, why the ECB was reluctant to launch this tool.

Read the original analysis: Spark Rates: Surfing the Perfect Storm

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