ECB policy meeting; US curve flattening (again)

ECB starts year-long strategic review. US curve could swing back to steepening.
Radhika Rao, Duncan Tan24 Jan 2020
    Photo credit: AFP Photo

    Eurozone: Back to externals after uneventful ECB review

    The only key takeaway from yesterday was the ECB signalling the official start of the year-long strategic review. The economic assessment, of stabilisation in growth and moderate increase in inflation, was seen along the central bank’s baseline expectations, warranting no change in the policy stance. There is a broad understanding now that monetary policy has hit its limits in lifting growth and boosting inflation, without further adversely impacting the financial system. Status quo is likely on the rates front, while any withdrawal from QE purchases is pushed back to next year.

    The strategic review, likely to be concluded by December, will involve a relook and assessment of ECB’s price stability mandate and its policy toolkit, amongst other things. Acknowledging the uphill task to arrive at a consensus, ECB’s Lagarde hinted that if there was no unanimity, it will be a majority decision. Compared to the prevailing “below but close to 2%” inflation target expectations are that it might be tightened to either a straight “2%” target (raising the bar for policy normalisation) or introduce some flexibility to achieving its price stability goal via a symmetric inflation target. Either way, there is bound to be fierce debates around these changes, which will consume much of the ECB’s time this year, with no change in rates/ policy stance in the interim.

    As noted in the Eurozone’s section of our G3 rates outlook (PDF, HTML), given the lack of immediate catalysts that could drive further curve steepening or much higher rates, we are reluctant to chase at current levels. With rate hike expectations not on the horizon and only modest fiscal easing upcoming, the supply / dynamics (with the ECB maintaining asset purchases) still point to generally depressed EUR rates.

    Rates: US yield curve flattening again

    A measure of speculative positioning on US curve slope, based on position differentials (futures) between short (Eurodollar, 2Y and 5Y T-Notes) and long (10Y T-Note, T-Bond and Ultra T-Bond) tenors, showed a swing of expectations from flattening to steepening until this week, when pandemic fears ensued. At present, USD IRS are pricing for 2s10s spread to widen from 11bps (spot) to 24bps (1Y forward). 13bps of steepening may seem underwhelming, but it is actually quite significant from a historical perspective. Looking back to 2000, the US curve has priced for steepening (on 1Y forward basis) on only 28% of the time, and when it did, it never priced for more than 30bps of steepening (vs max 145bps priced for flattening).

    Assuming pandemic fears dissipate soon, the combination of Fed buying Bills and US Treasury restarting 20Y Bond issuance could provide impulse for steepening. Over the longer-term, inflation could be a potential game changer with the Fed seeming intent on engineering higher inflation. Chair Powell has been reiterating that he would need to see “a significant move up in inflation that’s also persistent” before considering hiking rates again. The Fed’s ongoing review of its framework could also see the introduction of inflation-averaging rules that would allow for some overshooting. Therefore, a Fed that would be somewhat slow to hike rates in response to rising inflation could drive a steeper curve. Tactically though, Wuhan virus worries and heavy speculative steepening positions suggests that it would be better to await better levels before establishing steepening trades.

    Radhika Rao

    Economist – India, Thailand & Eurozone

    Duncan Tan

    FX and Rates Strategist - Asean

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