Strategy Daily

Evelyne Gomez-Liechti | Multi-Asset Strategist (Mizuho International Plc) |

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Rates markets remain hostage to oil and geopolitics ahead of Wednesday’s FOMC. Any brief optimism around Iran diplomacy yesterday proved short-lived, with USTs reversing lower again overnight as crude resumed its ascent and 10Y yields pushed back above 5.0%. The market is increasingly being forced to price a world where one chokepoint becomes two, keeping the risk premium in energy markets elevated. Recent reports suggest repairs could take several weeks rather than days, helping Brent remain comfortably above $100pb for the time being (if no diplomacy is found). For rates, this remains an underlying bearish catalyst in the near term. The combination of higher oil, geopolitical uncertainty and a Fed expected to deliver another hike this week has pushed investors into a one-way mindset: payers remain favoured, curves continue to flatten and there is little appetite to re-enter duration longs. With >90% odds of a hike already priced for Wednesday and forwards pricing almost 100bp of hikes in the next year, it may take a material easing in geopolitical risk to reverse the sell-off sustainably.

Monday’s bear-flattening pushed EUR 2s10s close to cycle lows and saw markets price almost 100bp of additional ECB tightening over the next year. Our concern is that markets are increasingly pricing the inflation impulse while underestimating the growth hit. Real EUR rates have jumped higher, with 1y1y and 5y5y real rates around 1-1.29%, respectively – a move away from the post 2010s equilibrium level of real rates. Is this justified? The renewed surge in energy prices undoubtedly raises the probability of further ECB tightening, but the Eurozone economy is not entering this shock from a position of strength. Q2 was stronger than expected, but overall growth remains fragile and labour market dynamics are gradually softening, especially in Germany and France. If energy prices remain elevated for a prolonged period, the debate will increasingly shift from inflation persistence towards demand destruction. We therefore remain cautious about chasing the sell-off at current levels but also stay away from entering longs given sentiment. German ZEW and today’s EU syndication will provide some colour on sentiment and demand, but neither is likely to compete with energy as the main market driver.

The UK remains at the epicentre of the rates sell-off. Gilt yields have pushed to levels not seen since the mid- 2000s while SONIA pricing has moved dramatically higher ahead of Thursday’s MPC meeting. Today’s labour market release does little to change that narrative. July private sector wage growth printed marginally above consensus at 2.9% on a 3M/YoY basis, while unemployment remained unchanged at 4.9%. The more notable development was another larger-than-expected decline in payrolled employees, adding to evidence that labour market conditions continue to loosen. GBP FX reaction has been muted, and the data should do little to alter the BoE’s reaction function this week. Tomorrow’s CPI release is now the final major hurdle ahead of Thursday’s MPC decision. The bigger story remains the disconnect between market pricing and the economic backdrop. Rising energy prices have pushed markets to price a significantly higher terminal rate path, with investors continuing to focus on inflation risks rather than the likely growth damage from a prolonged energy shock. Separate from the front-end story, reports that the BoE could exclude long-dated gilts from future QT sales may provide some support to the long end of the curve. While such a move would not be a major surprise and has been discussed for some time, it would nevertheless reduce a persistent source of duration supply at a time when long-end yields are trading at multi-decade highs.

Risk-off session in Asian equities, with rising energy prices and worsening sentiment taking a toll in this space too. JGBs bear-steepened following headlines of a potential increase in defence spending (to 3.5%…