Underperformance of US Treasuries today?

Rates

Global core bonds traded mixed with Bunds outperforming on the back of a bigger than expected drop in Spanish and German CPI readings. German inflation declined from 2.2% Y/Y to 1.5% Y/Y in February, suggesting that the ECB has more breathing room to hold on to its ultra-easy policy and fend off external pressure to start normalizing its monetary policy in the near term. The Bund had an intraday upward bias, while the US Note future lost some ground in the US session. Bund gains remain contained though. US eco data printed mixed and had no impact on trading. Stock markets eked out small gains while Brent crude increased above $52.5/barrel, improving the technical picture.

At the end of the day, changes on the German yield curve ranged between -1.1 bp (10-yr) and +01 bp (2-yr). The US yield curve bear steepened with yields 1.2 bps (2-yr) to 4.9 bps (30-yr) higher. On intra-EMU bond markets, 10-yr yield spreads versus Germany widened up to 2 bps with Portugal outperforming (-4 bps).

Heavyweight NY Fed governor Dudley, close ally to Fed chairwoman Yellen, said overnight that risks for both economic growth and inflation over the medium to long term may be gradually shifting to the upside. His main argument is the stimulative shift that US fiscal policy will make under US President Trump.
Therefore “it seems appropriate to scale back monetary policy accommodation gradually in order to reduce the risk of the economy overheating, and to avoid a significant inflation overshoot in the medium term”. Dudley said that the Fed isn’t removing the punch bowl yet, but they’re adding a bit more fruit juice. Dudley’s comments confirm remarks by Boston Fed Rosengren yesterday. The mind-set of the Fed seems to be changing from “keeping policy unchanged unless eco data are really, really strong” to “tightening at a regular base unless eco data really, really disappoint”. We hold our view that the Fed will raise its policy rate 3 more times this year. That’s 1 hike more than the current median FOMC projections and more hawkish than market positioning (1.5 hike discounted).

Dispersion US & EMU inflation?

The main items on today’s eco calendar are EMU (CPI) and US (PCE) inflation. Following lower-than-forecast German and Spanish inflation readings, risks are on the downside of expectations.

Consensus predicts a decline of headline inflation from 2% Y/Y to 1.8% Y/Y, but also a fall in core inflation from 0.9% Y/Y to 0.8% Y/Y. The US PCE deflator is expected to rise from 1.9% Y/Y to 2.1% Y/Y, exceeding the Fed’s 2% inflation target for the first time since Q1 2012. Core PCE is forecast to stabilize at 1.7% Y/Y. Other eco data will probably be less relevant for trading today with US personal income/spending, Chicago PMI, final Michigan consumer confidence and German unemployment data. Fed Dudley (spoke yesterday), Kashkari (dissented March rate hike) and Bullard (arch-dove) are scheduled for public appearances, but we don’t expect them to impact trading.

Underperformance of US Treasuries today?

Overnight, most Asian stock markets cede ground with Japan and China slightly outperforming. However, risk sentiment is worsening at the end of trading. Chinese PMI’s printed strong while Japanese eco data were mixed. Hawkish comments by NY Fed Dudley don’t weigh on US Treasuries. We expect a neutral opening for the Bund.

The focus for today’s trading session will be on inflation data (EMU CPI and US PCE deflator). The dispersion between EMU (declining inflation) and US (rise above Fed’s 2% target) should cause underperformance of US Treasuries vs German Bunds today. Against the background of recent Fed talk, it could mark the start of a new decline within the sideways trading channel of the US Note future. The German Bund reversed the decline on the back of speculation on an earlier than expected exit. Today’s drop in inflation might cause another uptick.

Technically, we expect the US 10-yr yield to trade in the 2.3%-2.64% range. Moves towards the lower bound could be used to offload bonds or position for higher rates. Longer term, we maintain our scenario of 4 rate hikes in 2017 and higher long term yields. The German 10-yr yield trades in the 0.2%/0.5% range and we hold a similar approach as in the US ahead of the French elections.

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