Looking out for new guidance, markets this week had been counting down to the ECB policy decision and US May inflation. The message from both ‘events’ was relatively straightforward. The market reaction, especially in US interest rate markets, was at least remarkable. The facts first. The ECB left its policy rates (deposit rate at -0.5%) and the PEPP asset purchases unchanged at €1850 bln. Staff projections raised the growth (4.6% 2021; 4.7% 2022) and inflation (1.9% 2021 and 1.5% 2022) forecasts for this and next year. However, ongoing low core inflation supported the narrative that most of current rise in inflation is temporary. This allowed the ECB to continue to conduct PEPP bond purchases at a significantly higher pace than during the first quarter. At the press conference, President Lagarde admitted some diverging views with the MPC. The ECB will be flexible on the amounts of bond buying when market liquidity is lower during the summer. However, the message was clear. The ECB will continue to facilitate accommodative monetary conditions during the summer. The reaction on European bond markets to the ECB decision was modest. German yields declined slightly more than 1 bp for the 5 and 10-y. However, European investors also had to keep a close eye at the developments in the US. US headline inflation jumped to 5.0%. Core inflation accelerated to 3.8%. Both were higher than expected. The market reaction was telling. A first ‘logical’ (but very tepid) rise in yields was almost immediately reversed and even resulted in an outright short-squeeze in Treasuries. At the end of the day, US yields declined between 1.2 bp (2-y) and 5.9 bp (10-y). Contrary to recent price action, the move was driven by a steep fall in real yields (10-y -10 bp!). Break inflation rose modestly (+3.4 bp). The 10-y US yield dropped below the key 1.47% support. There is no evident explanation. Despite the higher inflation, investors apparently concluded that enough inflation risk is discounted. The decline in real yields suggests that the Fed is expected to take a very cautious approach on tapering. To be confirmed at next week’s Fed meeting. The big moves on the US interest rate markets had only modest impact on other markets. US equities recorded decent, but no excessive gains (Dow +0.06%; Nasdaq +0.78%). The impact on FX markets (dollar) was close to non-existent. The DXY closed in well-known territory (90.07). EUR/USD closed at 1.2170 (from 1.2180 on Wednesday). Sterling reversed Wednesday’s modest setback. EUR/GBP closed again below 0.86 (0.8588).
Today, the eco calendar is thin with the US consumer confidence (U of Michigan) the exception to the rule. The focus remains on the interest rates, with the German 10-y (-0.25% ) at and the US 10-y yield (1.44%) below key support levels. From a fundamental point of view, the correction probably went far enough as long as a constructive economic scenario is assumed. Still, ongoing repositioning ahead of next week’s Fed meeting might cause additional volatility. The dollar held resilient despite the fall in real yields. The EUR/USD 1.2104/1.2266 range isn’t questioned.
South Korean bonds are under pressure this morning after BoK governor Lee said the current accommodative stance should be normalized again at an appropriate timing if the solid recovery is forecasted to continue. The Bank of Korea in recent weeks sent more signals in that direction, including deputy governor Park Jong-seok yesterday saying one or two hikes from the current low levels shouldn’t be seen as monetary tightening. His comments came after a monetary report in which the BoK flagged risks of accelerating inflation and financial imbalances. The South Korean won strengthens to USD/KRW 1110.10.
Bank of Canada Deputy Governor Tim Lane said the pick-up in inflation to above 3% was one of the key issues on the table during the policy meeting on Wednesday. Officials agreed the higher-than-expected inflation was due to base and other transitory effects. The central bank expects price developments to be above 3% through the summer before easing again on the remaining slack. The BoC was one of the first to start tapering its bond buying in April and is expected to take such a step again next month. By emphasizing the temporary nature of inflation, the BoC is trying to make sure markets aren’t getting ahead of themselves with respect to the anticipated policy normalization.
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