Global Rates: Front end EUR and UK rates, cross-market duration and intra-EMU spreads

Francis Diamond (0:03)

Hi, and welcome to At Any Rate, JP. Morgan's Global Research Podcast Series, where we take a look at some of the drivers behind the biggest trends and themes across fixed income currencies and commodity markets. I'm Francis Diamond, Head of European Rate Strategy at JP. Morgan. And today, I'm joined by my colleagues Khagendra Gupta and Aditya Chordia to discuss several topics. We'll focus on year-era money market pricing, duration curve thoughts, intra-EMU spreads, and UK rate markets post-November BoE meeting. So just to start off this week, seen a decent repricing of ECB and BoE terminal rate expectations with now around 70 and 90 basis points of further ECB and BoE hikes price respectively by the end of next year. And 10-year Bund and Gilt yields have sold off as well. The catalyst for these moves has been a combination of rising TTF and UK natural gas prices.

And also the main driver for the intermediate part of the curve has been the sell-off in dollar rates following the stronger than expected US CPI print for October.

Khagendra, let's just focus a little bit on the front end of the euro curve and ECB expectations at a price. The mini curve looks like it's pretty much pricing a 25-base point hike at the December meeting and a total of 70 basis points ECB hikes by the end of next year. So does that look reasonable in your view?

Khagendra Gupta (1:18)

Hello, Francis. Yes.

As you mentioned, the euro curve has repriced significantly higher this week, with the terminal rates moving around, let's say, 16 to 18 basis point higher on the back of the US inflation data.

There was some hawkish Fed speeches and also rising energy prices. Although I would highlight that the beta of ECB pricing energy moves has been rather choppy or weak over the past few weeks compared to what we had seen in the initial phase of the repricing higher. Our own expectation is for the ECB to hike 25 basis point each in December and March, and we see some risk of another hike after that. So I think a peak pricing of around 60 to 65 basis point is fair, but with current valuation of 70 basis point or so being towards the upper end of our expectations. So I find front-end yields marginally cheap, but I'm not rushing to fade these moves either. These yields can remain sticky around current levels for several weeks, as we had seen in October, and therefore we find that fading these via bullish option structures targeting the second half of 27 or 1H or 1Q28 sector to be more attractive.

Francis Diamond (2:40)

Okay, so Aditya, let's shift to intermediate public curve and bund yields.

So 10-year yields and bunds have sold off back to around the 340% level, 10-year treasury yields around 5.10. I mean, do you think there's any value in bunds on a cross-market basis at these levels? And what about the broader German curve? How do you see this evolving going forward?

Aditya Chordia (3:02)

Sure, Francis, yeah, like there has been a significant sell-off in this week, and that's being a reminder of the point we have been stressing for a while, that the near-term Euro-area duration remains highly headline-driven. And this week, the move was driven primarily by a sharp repricing higher ECB tightening expectations, as Khagendra mentioned, on combination of bounce-back in energy prices and also beta to the sharp repricing higher in the Fed tightening expectations.

So, yeah, near-term, clearly things have gone a bit too far, and that's what our stance has been, which is a medium-term constructive outlook, which is still intact. Like with market-based neutral rates now, again, pricing above 3%, like 3.1 or so, versus below 2-3% a week back. We continue to see scope for gradual drift lower over time, a little bit in a less one-way fashion. And we also expect that the elevated correlation of neutral rates to the US, which we saw this week, we expect to decline going forward because the latest Fed repricing has been driven by more US specific factors, with much more limited reach across the Euro area. We don't expect ECB to hike because the Fed is hiking. And therefore, we continue to find the intermediate level of yield is quite attractive for long-term investors. That has been our messaging for a while. And I think it stays a very high-conviction view we have, that 3%, any yield which is above 3% is a great level to log from a medium-term point of view, if you have risk appetite to withstand any item volatility.

As you asked on the cross-market, we have been pushing this over with Germany versus US down, especially in the intermediate part of the curve. And after this sharp US underperformance of this week, we are neutralizing that. And on German curve, this week we did see a bit of a bear flattening, and that it was more ECB repricing driving the sell-off, which is a typical direction that you see in those type of moves. But over the recent weeks, the two-cent direction has been much more choppier, particularly in rallies, as volatility has rotated between the front end and the intermediate sectors. In our view, this reflects a market increasingly pricing a stickier front-end yields, especially when we are getting close to market pricing to cut two hikes or another 50 basis for hikes from ECB. Reaching that point, I think market was saying Central Bank is going to go on a pause of the hiking cycle by March next year, and in that world, you have the volatility shifting from the short end to the intermediate part of the curve. That's where you start seeing this bull flattening, bear steepening sort of dynamics.