Euro Rates: First hike now priced in for July – Following a barrage of dovish ECB commentary, financial markets have priced in a slower withdrawal of monetary stimulus. Earlier this year, financial markets were pricing in a 70-80% chance of a 10bp rate hike by December 2018. Having scaled back these expectations sharply, investors now expect the first rate hike in July 2019, according to ECB-dated EONIA forwards. Investors were pricing in an immediate end to net asset purchases in September as well as a very quick start to the rate hike cycle after that. It seems that financial markets have shifted to price in a longer tapering of net asset purchases after September and/or a longer gap between the end of purchases and the first rate hike. We judge that this re-pricing is now advanced (our base case is the first hike will be in September – see below).
The shift in ECB expectations has left its mark on rates markets. First of all, we have seen a significant fall in German government bond yields. We have seen 5y yields falling more than 2y yields, which has led to a flattening of the 2s5s part of the yield curve. The 5-y segment at this stage seems to be more sensitive to rate hike expectations. However, there is more at play, as 10y yields have fallen by more than 5y yields, with 5s10s also flattening. The correction in yields at the long end may also reflect some tempering of cyclical expectations, given ongoing weak underlying inflationary pressures, a softening of cyclical economic indicators and the risk of trade wars. Longer term yields may also have been impacted by the view that net asset purchases may be ended only after a relatively long taper. Indeed asset swap spreads have re-widened, consistent with the slower exit story. This change in ECB expectations has not had much impact on currency markets on the surface. The euro has not weakened as would be expected. This may be related to negative developments elsewhere. For instance, political risk may have weighed on the dollar.
We continue to think that the ECB will set out a clear roadmap for the end of its asset purchase programme in June/July. We expect a tapering period of 6 months (3 months EUR 20bn p/m and 3 months EUR 10bn p/m). We do not expect the first rate hike to follow until the second half of next year (10bp in September and another 10bp in December). We expect the ECB to maintain or even strengthen its forward guidance on interest rates when it announces a wind down of net asset purchases (Nick Kounis).
US Macro: Manufacturing strength offsets weaker consumer spending – The ISM manufacturing PMI fell to 59.3 in March from 60.8 in February, but this was fairly close to expectations (consensus: 60.0; ABN AMRO: 59.5). Big picture, the index remains elevated, with the 3-month average still at a post-crisis high. Alongside an increase in construction spending for February, the strength in the ISM helped lift the Atlanta Fed’s GDPNow tracking estimate for Q1 to 2.8%. The estimate had fallen to as low as 1.8% following a run of weakness in retail sales numbers. While retail sales in the US is notoriously volatile, the passing in the baton from the consumer to businesses is nonetheless consistent with our view that investment would take the lead in driving GDP growth this year. Also notable was the impact from the recent steel and aluminium tariffs in the prices paid component of the ISM. This picked up to the highest level since 2011, with survey respondents pointing to steel & aluminium price rises ahead of the tariff implementation, which were at least in part driven by ‘panic buying’. This could put some upward pressure on PPI inflation at a time when commodity prices more broadly are exerting upward pressure. We suspect such an impact will be short-lived, however, given that the biggest exporters of steel and aluminium to the US were ultimately exempted from the tariffs. (Bill Diviney)