The German Finanzagentur taps the on the run 2-yr Schatz

Rates

Yesterday, the corrective up-move on bond markets in the run-up to the FOMC meeting initially continued, but in US dealing the gains largely evaporated.
German yield changes ranged between -0.6 bps (10-yr) and +2.3 bps (30-yr). The 2-yr yield (+1.2 bps) underperformed ahead of today’s Schatz auction. In the US, yield changes vary between -1.3 bps (5-yr) and +1.7 bps (30-yr).

Today, the focus is on the FOMC meeting, but earlier, the EMU and US CPI inflation data and US NAHB housing market index will be released. ECB Mersch speaks, the BoE releases the minutes of its latest MPC meeting and Germany and Sweden tap the market. In EMU, the final reading of August CPI inflation is forecast to confirm the first estimate, which showed a further slowdown to 0.3% Y/Y from 0.4% Y/Y. Although inflation will most probably be confirmed at 0.3% Y/Y, an upward revision is not entirely excluded as CPI surprised on the upside in Portugal, Greece and Ireland. In the US, CPI inflation is forecast to have eased slightly further in August, from 2.0% Y/Y to 1.9% Y/Y. Downward price pressures will mainly be based in food & energy, which will be offset by a higher core CPI. Due to the strong drop in energy prices recently, we believe that the risks for the headline reading are for a downward surprise. Core CPI, on the contrary, is forecast to have stabilized at 1.9% Y/Y. For the core reading, we believe that there might be upside risks. Finally, the NAHB housing market index is expected to extend its recovery in September. We see risks for an upward surprise.

The FOMC will most likely decide to taper its asset purchases by another $10B, setting the scene for an end of the programme at the October 28-29 meeting.
Market reaction will be triggered by three issues. Will the FOMC change its forward guidance, dropping the phrase that the Fed will keep rates at current low levels for a considerable period of time after the end of QE? We think they will and replace the timing of the lift off by referring to further progress in meeting its dual mandate. This allows the Fed to adapt policy faster when needed. The Fed will need to walk a fine line between injecting a two way risk in the market on the lift-off on the one hand, while avoiding a market overreaction on the other. According to the WSJ, the “considerable period” comment will stay in the statement. Secondl the “dots (rate projections). We expect a slight increase of the 2015/16 median rate projection and a 3.5% rate projection for 2017 (first projection). If that’s the case it is a negative for markets. Especially the 2017 projection might be a “shocker”, as it is about 70 bps above current expectations. Finally, there is the press conference. If the Fed is bold on the forward guidance change and (high) dots, Yellen might choose to be soft. If little to nothing happens on these points, she might be hawkish in her comments.

The German Finanzagentur taps the on the run 2-yr Schatz (€4B 0% Sep2016). The relatively low amount on offer is expected to be digested despite the negative yield (not the first time at Schatz auction!) though we don’t expect a stellar auction. The bond cheapened around 4 bps in ASW spread terms in the run-up to the auction, but trades rather rich at the front end of the yield curve.

Overnight, most Asian equity markets trade somewhat higher. Overall, we would say that the Asian performance is rather disappointment given WS’s strong finale (rumours Fed won’t change forward guidance). Especially when taking into account that China’s central bank, according to rumours, injected around $81B into the banking system. The US Note future trades modestly higher.

The eco calendar contains EMU (final) and US CPI data. However, these will be completely overshadowed by the FOMC meeting. We see risks on the hawkish side of expectations with a change to the forward guidance and higher Fed rate projections (“dots”). If that scenario proves to be right, we expect higher US rates with an underperformance of the 5-yr area.
Technically, 2.8% is the next resistance in (10-yr) yield terms. For the US Note future, first stops on the downside are 123-23+ and 123-10, targets of a double top formation with neckline at 124-27. The impact on the German Bund/yield curve should be similar though to a lesser extent of course (underperformance US Note future versus German Bund). Nevertheless as we’ve seen from May to September last year, higher US yields because of the normalization of FOMC policy pull European yields along despite the different economic context and monetary policy stance. The German 10-yr yield should be able to retake 1.12% resistance with downward pressure on the Bund (break below 147.77/92).