The US Treasuries curve bear steepened rapidly over the past week as a series of non-US shocks hit. 10Y US yields are now back close to 4%. Events wise, we are concerned about a few matters. First, there are still a lot of uncertainties over how GBP rates will pan out in the immediate few weeks. Gilts got sold hard over the past few weeks as the market worried about the UK’s fiscal position under proposals made by PM Liz Truss. The disorderly selloff in Gilts prompted the BOE to embark on emergency bond buying. However, after announcing a series of liquidity measures (largely repo), the BOE indicated that it plans to stop bond purchases by the end of the week. This means that the “put” on long-dated Gilts will be gone soon and unfortunately, this might mean more upward pressure on Gilt yields as market participants test the BOE’s pain points. If markets get disorderly, an extension of bond buying might be needed.
The next checkpoint will probably be 31 October when fiscal plans and economic forecasts get announced. Depending on how this hurdle gets cleared, this might have implications on whether QT will proceed. There is also BOE’s monetary policy on 3 November to consider. A large hike appears inevitable, and the final size might well depend on the reaction of the GBP as well as GBP rates behave. Second, speculation that Germany might support joint EU debt for loans to cushion the energy crisis might not go away easily. This led to a rebound in core EGB yields over the past few days as BTPs outperform. This issue here is an extra load of debt issuance that has got to be digested by the market if proven to be true. Secondary considerations on this issue are that Eurozone growth might be better supported, proving the ECB with more leeway to hike rates. Broadly, this means that fiscal and monetary policy look in conflict in the UK and potentially in the Eurozone. Third, we would also keep an eye on the BOJ. While the BOJ has been steadfast in holding on to YCC, pain points on yen weakness have been hit. Risks of a YCC shift is rising and we will be watching to see if the authorities judge smoothing operations on the USDJPY to be sufficient.
With this mix of events (and even without considering the OPEC supply cuts), there are suddenly factors that drive long-end DM rates higher, going against the grain of flattening that usually takes place when central banks are hawkish. We would also argue that BOE tightening magnitude risk is probably even higher than that of the Fed where 75bps is pretty much baked in. A Jumbo hike (100bps) could well have repercussions on short-term DM yields. The reaction on the back end would be more difficult to gauge. However, a more aggressive BOE would probably lead to a flatter Gilt curve and therefore DM curves in general. Note that these exogenous shocks to the US are arguably as important as US data in determining where UST yields go, and also underscores the complexity of the current trading landscape. Just as the world cannot ignore the Fed hikes, it might not be so easy for USD rates to decouple from swings in the Eurozone and the UK. Spread plays might well work better in this uncertain environment. Long-end SGS and to a smaller extent, UST, might well be more resilient than EGBs and Gilts in the short term. Term premium might well have to be higher in this environment and can be proxied by extremely high implied volatility in rates. This makes curve calls more difficult in the short term, but we would expect flattening to take hold over the coming few quarters. Timing wise, as a guide, we think that if the financial conditions index is at -1.4 or lower, the risks of chasing long end US rates higher on an outright basis is too high. At these levels of stress, severe risk aversion might kick in, driving yields lower.
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