The Week Ahead in Euro Rates

1. 2s5s flips back to bearish flattening. Fade it. Bearish flattening is the right dynamic – the bullish flattening in recent weeks didn’t fit a soft-landing story. But I don’t believe in the pricing of the peak ECB rate pushing toward 3.6%. That should correct, but if not, I also see the 5y as stretched.

2. The long end is starting to steepen. Go with. Supply seems to be starting to work its magic on the part of the curve that was most squeezed by QE. Supply will be heavy again in the long end next week (Germany? Belgium? EU?) and all year. The bearish flattening regime was one thing when policy rate catches up was driving. It’s another thing as the baton is passed to QT. 10s30s steepening is a 2023 theme to stay with.

3. Money market confusion and liquidity. When governments need to place cash in the market, they won’t go to what’s squeezed. French repo will look more compelling than German. Benchmark rates aren’t threatened. Schatz spreads are broadly fair.

1. Changing curve dynamics (1): Front endThe front end went back to bearish flattening this week. That makes more sense but fade it. Since the December ECB meeting, 2s5s has had a strong tendency to bearish steepen. The logic was that the front end was quasi-pinned around 3.5%. When rates rose, it was the more volatile 5y which led. The problem was that this was at odds with the data pointing toward a softer landing. This week, particularly as I write on Friday, the more logical dynamic is reimposing itself as the market prices in a peak policy rate approaching 3.6%. Despite the internal logic of the switch back to bearish flattening this is an opportunity.

Above all, I strongly disagree that the risks are skewed toward a policy peak above 3.5%. The real policy rate is already clearly restrictive – the real policy rate will reach 1.45% in coming months, if you take the care (as you should) to look at the current trend in inflation rather than continuing to include historic shocks. Lending conditions are tight, loan demand weak, and low gas prices and higher rates than in December very likely mean the ECB will cut their inflation projections substantially in March. A lower peak, a softer landing, and a longer peak is still much more likely than the markets assume.

So, I look to the week ahead for a steepening correction in 2s5s. Our preference (and expectation) would be for pricing for the policy peak to drop back again. But I also expect that we may see a bearish catch-up from the 5y area. Corporate supply returning more strongly after blackouts may help. I suspect that delta-hedging of spread floors may also have been part of the flattening move. If so, gamma will encourage the steepening correction too, while conversely, as we move below likely strikes, excess flattening pressure from dealer hedging should abate.

Key risk: drift. The main problem in the next week (or two) is that there’s not a lot on the data calendar that’s likely to change expectations in a bullish steepening direction soon. European CPI details will be more useful than usual given January effects and the focus will be US CPI. For what it’s worth our US economists see risks on the low side of the consensus, which in any case is for y/y core to drop slightly to 5.4%.

Market conclusions: (1) 2s5s steepeners (target level 35bp). (2) The volatilityweighted version is more compelling for us, but the volatility weighting is aggressive: the current regime suggests 165:-100 PV01 weights (target 6bp profit). (3) That volatility ratio also suggests the steepener in swaptions where the vol ratio is priced at around 110:100. I like the steepener in 1m payers – we’d expect resistance much earlier in the front end. The small give up (around 2.5bp) is worth the reduction in exposure to bullish flattening on weaker data.

 2s5s since December 16th scatter against 1y1y and linear residual2. Changing curve dynamics (2): long endThe long-end is rarely as confused as the front end about its directionality – bearish flattening/bullish-steepening is the dynamic with very few exceptions. But there are exceptions. The most important were early 2015 (the start of QE), summer-2019 (NIRP and Japanification panic) and 2020 (pandemic and PEPP). Note that all were linked to either monetary policy decisions or deflation fears driving longer-term expectations. No one expects a return to those circumstances - the paradigm has shifted. But we are still in the pandemic regime, albeit infinitely extrapolated to higher rates. A correction is due.

But there are signs the regime is shifting. 10s30s is already at the steep end of where you’d expect given the level of shorter-term rates. Even quite short-term PCA studies show the long end looking cheap. I think this is the start of one of the big themes of 2023 – bearish steepening. It’s one to go with.

Skepticism about bearish steepening is natural. The experience of the past year is that the curve bear-flattens and that steepening is therefore a bullish trade. I agree only partly: in a rally the curve is very likely to steepen. But will the curve only bearish flatten? If the ECB rate continues to rise toward 4%, yes, undoubtedly it will. But the dynamics are very likely to change in 2023. Last year the voracity of catch-up rate rises drove nearly everything. This year, the central bank cycle will be less important. QT will take over as the only policy with staying power (‘staying the course’ will take a different meaning!). Supply will weigh. Indeed, the changing dynamics already suggest that supply does matter after all and there’s a lot more to come.

January’s disinflation euphoria is entering a more difficult phase. After having absorbed €250bn of bonds in the first month of the year, we have seen signs this month that there is indigestion in the market. Markets will need constant confirmation that disinflation is happening fast enough to buy more. Other than US CPI next week there’s not much that might give that comfort until the business surveys the week after next.

Beyond the simple disinflation narrative, which may or may not be tracking, the demand fundamentals haven’t been improving. Foreign demand is just as likely to remain weak as the curve flattens. Global unconstrained money is just as likely to view fixed income as risk-additive rather than diversifying. Since the start of the war in Ukraine stocks and bonds have moved the same way in 70% of weeks. This is not risk-on/risk-off.

 Equity-bond correlations have never been higher… stillAnd Banks are just as likely to avoid duration as they were this year. An acceleration in term deposits received and weaker loan growth is a small caveat, but that’s probably dominated by slower deposit growth.Supply next week will maintain the pressure. Long-end Germany, and possibly Belgium and EU – see below for the full run-down.

 Regimes in 10s30s since 2000. Mostly bearish flattening and bullish steepening, but with important structural breaks. Another break is due.Market conclusions: 10s30s steepeners in swaps are still the go with trade. Swaps are the right instrument to be short in the long end because paper is likely to be bought partly on asset swap by financial institutions.

3. Surprise announcement on the remuneration of government… a positive surprise this time aroundGovernment deposits at the ECB will be remunerated at €STR-20bp as of 1st May. The timing was confusing, but the move makes sense. It makes sense to smooth the transition and it makes sense to experiment to find the sensitivity in money markets to government cash. The market is better balanced already and will become better balanced still by May. If the experiment is successful (i.e. short-term rates do not just fall by 20bp) the ECB’s next step should be to experiment with bigger cuts: say widening the spread to 50bp and then 100bp.

No risk to Schatz spreads or specials, but richer semi-core repo? I don’t think that short-end rates will fall as far as the new spread to €str for government deposits widen, but there may be some risk that high-quality investments are somewhat better bid. Anything subject to ‘squeeze’ will not be squeezed further, however. Semi-core repo may be bid compared to German repo, closing the spread further, for example. I don’t see a risk to €STR, which I expect to be broadly stable. I see even less risk to Euribor, which I expect to stay much tighter to €STR than projected in the markets. Asset swap spreads have probably reacted as far as they need to on this – Schatz spreads, for example I see in a fair-value range of 40-45bp vs €STR (although I see the spread against 6m Euribor tightening further).

Market conclusions: Fair for now. I expect asw to tighten towards through this year, target 10y asw at 50bp for Q4.

TLTRO profile… less excess liquidity will help

 Government deposits at the ECB Supply: Little respite for marketsA chunky €29.3 bn (PV01 ~€18m/bp) expected in supply from Germany, Italy, France, Spain, add to that ~€6bn in EU syndication. Another hefty week of supply for markets to grapple with, syndications likely will add to this week’s heavy load. A Belgian 20 year is quite likely in the next week as a typical February issuer. An Italian (inflation-linked/long-end) bond is also possible, but unlikely I think given Italy is also auctioning a 3y, 7y and 15y. Little respite for markets but the €20.5bn in redemptions and €2.5bn in coupons should offset some pressure.

The big hitters of last week, the French syndication and DDA were well received. The 30-year French syndication was received with open arms by the market, orders of more than €35bn for the €5bn printed, and strong performance in the day that followed. The 10-year Dutch DDA saw spreads settle at +33.5bp in line with our estimation of +34bp and with strong demand. Regularly scheduled auctions were a bit more mixed, Austrian auctions were soft with lower bid-to-covers and wider tails, German linkers saw good demand, but cover on the 7y auction was lower than usual. The Portugal 10y saw strong demand with overbidding and a higher bid-to-cover. Overall supply so far has been well digested by markets this year, but I think a turning point should come soon as markets grapple with a significant step up in supply in 2023 versus 2022.

European corporate supply is expected to pick up in the next week, marking the end of earnings season. Strong issuance and strong demand are set to continue. Risk markets are set to perform as growth and inflation optimism take the markets by storm.

ECB purchases: Drop for FebruaryECB gross purchases slowed at the start of February, down to €9.5bn from €12.5bn. Patterns over the last two years suggest that purchase pace drops in February, and I won’t be surprised if there is some sort of taper ahead of the QT start in March.

Data: GDP and unemploymentUpcoming we get preliminary GDP figures for Q4. These should confirm the advance numbers in January that suggested that the Eurozone expanded in Q4. Small margins here though, the improvement was 0.1% q/q, expectations were -0.1 q/q. PMI employment figures were buoyant last month, and labour markets have been resilient so far. I don’t expect any significant surprises on the employment data next week.

ECB events ahead: More central bank speakers to come, more unhappy hawks?It has been resoundingly clear that inflation has been top of mind for ECB hawks, and that they don’t think March will be the end for ECB rate hikes. We’re likely to hear the same message once again next week, but Lane should provide some balance with his usual dovish message. On the agenda is Lagarde at Eurogroup and in a plenary debate, Panetta discussing monetary policy and the energy shock, Guindos at ECONFIN, and Lane giving a lecture which should give us a different point of view and some good charts.

The ECB economic bulletin will be published on Thursday with pre-releases through the week. The pre-release on Monday will include thoughts on fiscal policy and high inflation. With risks to growth and inflation more balanced since the December meeting it should be an interesting bulletin and could provide more colour on last week’s decision.

ECB publication highlights last week: Professional forecaster surveyLittle change in the ECB’s survey of consumer expectations for December. Consumers expected their nominal income to grow by 1% over the next 12 months, up from 0.9% in November - it doesn't look like a wage-price spiral is an issue for now. Median expectations for inflation over the next 12 months were unchanged at 5.0%, while median expectations for inflation three years ahead edged up from 2.9% to 3.0%. The good news is that uncertainty about inflation expectations 12 months ahead eased somewhat compared with the levels observed since mid-2022.

The PEPP country-by-country breakdown for December and January highlighted that France was overbought and that Italian spreads are holding out without much help from the ECB.

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