Spark Pricing: Hawkish Flattening Drive


mario guti

By Benjamin Schröder, Antoine Bouvet, Padhraic Garvey, CFA

Gilts lead sell-off, caught between BoE and fiscal measures

As the hawkish message from this week’s series of central bank meetings hits, rates markets remain under pressure, with forward-mid rates initially underperforming. The German 2y10y curve came close to inverting and only steepened as the yield on the 10yr Bund pushed towards 2%.

Still, it was the Gilts who led the sale. On the face of it this was surprising as the Bank of England disappointed market expectations with a 50 basis point weaker than expected hike, but the Bank later added that the impact of the government’s fiscal package would not would be considered at the next meeting. With the promise to act forcefully if necessary, this leaves the door open for substantial increases later – 75 basis points not ruled out with three favorable votes from the Monetary Policy Committee already this time around.

However, it is also the dynamics of the supply of gilts that weigh heavily. The BoE announced yesterday its intention to launch active sales of its bond holdings in October. This would equate to a portfolio reduction of £80bn over the next 12 months, with half of these sales, the other half being a passive roll-off. These numbers weren’t entirely unexpected, but under current market conditions and given that government energy spending plans could create unpredictable upside risks to gilt issuance, it puts private gilt investors in an awkward position. We are not ruling out 10-year gilt yields at 4% soon.

Tax measures and QT add to an impressive amount of gilt supply

Tax measures and QT add up to an impressive amount of gilt supply (Refinitiv, ING)

Transmission and cost issues as tariffs are increased

A more technical aspect facing central banks as policy rates are raised from zero or below into positive territory was highlighted by the Swiss National Bank yesterday. He raised the policy rate from 75bp to 0.5%. But to ensure that the market rate actually tracks the higher policy rate, he introduced what is essentially a reverse-tiered system. Demand deposits are now remunerated at the policy rate up to a multiple of individual banks’ reserve requirements, and anything above does not earn interest. Basically, this will force banks to participate in SNB repo operations, and bond issues have been introduced in parallel to mop up this remaining excess liquidity, ensuring that the overnight rate actually trades at the key rate.

The European Central Bank has also faced the problem that its rate hikes are not properly transmitted to all corners of the money market. The scarcity of collateral is affecting base rates, with German 3-month treasury bills still trading around 40 basis points below the ESTR OIS (swap indexed to the short-term euro overnight rate), for example. The ECB prevented at least a worsening of the situation by remunerating the government’s vast cash holdings with national central banks that would otherwise have pushed into the tight collateral market. But this is only a temporary solution and the ECB could consider the approaches of other central banks, in this case the SNB issuing central bank bills – which essentially converts excess liquidity into collateral. It does not address the problem of the ECB, which finds itself with an increase in interest charges when it has begun to remunerate banks’ excess liquidity.

German 2-Year and Bubill 3-Month Swap Spreads Against Oil - Scarcity of Collateral Means Higher ECB Rates Not Fully Passing On To German Bonds And Notes

Scarcity of collateral means higher ECB rates not fully transmitted to German bonds and bills (Refinitiv, ING)

Today’s events and market view

Eurozone PMIs are expected to fall further below the 50 mark as high energy prices bite and force cuts in manufacturing output. Yet ECB officials have already begun to prepare markets for the difficulties ahead, signaling their intention to remain focused on inflation and raise rates despite an economic slowdown. This had boosted the yield curve flattening momentum, and while yesterday it was already close, the Bund curve should eventually follow the OIS and tip the curves into inversion.

Gilt markets will focus on today’s tax event and what it will mean for the issuance. The implications for the BoE’s next policy decisions will be at least as important, as the Bank has already warned that the government’s energy program will increase inflationary pressure in the medium term.

Elsewhere, we’ll follow comments from the ECB’s Martins Kazaks as well as the Bundesbank’s Joachim Nagel alongside the SNB’s Thomas Jordan. Later today, Fed Chairman Jerome Powell will open a “Fed Listens” event with Fed Vice Chairman Lael Brainard and Michelle Bowman.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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