Ebury: Bond collapse … continued as the Fed moves away

By Enrique Diaz – Alvarez *

The most dramatic movements in the financial markets last week took place in the fixed income markets.

Bonds continue to crumble as the Fed moves away and no one else seems interested in buying them. What is remarkable is how little the dollar has benefited from the rise in both nominal and real yields, which has left the Treasury Department’s 10-year bond flirting with a two-year high of close to 1.8%. The euro held extremely well, firmly ending the week against the dollar, while sterling really managed to break away again and finish at the top of the G10 currency rankings. Emerging market currencies moved in a mixed field, but, again, the movements were not dramatic given the turmoil in the bond market.

The focus is now on the December US inflation report, which will be released on Wednesday. Inflation reports will also be issued for some emerging market currencies, so any indication that inflation is peaking could be the catalyst for a rally. However, the climate in the bond market is fragile after last week’s brutal sell-off and another upward surprise in US inflation could be a test. If that happened then we would all be in for a rude awakening, at least in the short term.

Sterling

In a slow, post-Christmas week, the pound outperformed all its major competitors, continuing to trade, boosted by the momentum of the Bank of England’s decision to lead the three major central banks in raising interest rates in December. This week also has some macro news. However, Deputy Governor Ben Broadbent’s speech Monday seems to add critical information about the MPC’s expectations for future increases, mainly because it is generally seen as intermediate in the range of conservative-aggressive (dovish-hawkish) rhetoric. We continue to see room for sterling overperformance at the back of the financial valuation and a relatively aggressive central bank.

Euro

Another month, another rise in inflation in the Eurozone. Contrary to market expectations, inflation rose again to 5% and 2.6% in core inflation, providing further evidence that inflationary pressures are spreading to the Eurozone. We believe that the next big change in the policy of the European Central Bank will be its recognition that the tightening of its policy can not wait until 2023. In this sense, the speech of the member of the European Central Bank Isabel Schnabel at the weekend stressed the possible inflationary consequences of the green energy shift, suggesting that an hawkish disagreement is beginning to develop within the ECB’s board. If and when the shift becomes more apparent, this could give a strong boost to the single currency.

US dollar

There were mixed messages from the two main elements of the US employment report in December: facility research (milder) and household research (much stronger). Overall, the report suggests that the US is now close to a reasonable definition of full-time employment and that expanding supply will not be enough to alleviate inflationary pressures in the short term. The prospects for any kind of fiscal tightening remain far away, and this only adds to the pressure on the Federal Reserve to start tightening policy earlier. At the moment, we expect a first increase in March and we believe that there is a possibility of four increases throughout 2022. Again, the inflation report to be issued on Wednesday remains a key focus for traders in any financial market. Expectations are for another decades-high rise in both titles and headlines, and we see no reason to disagree.

*Chief Risk Officer of the international payment company Ebury. The company’s analysts were named by Bloomberg in the first place of the most successful forecasts for the EUR / USD exchange rate in the fourth quarter of 2020.