Bonds: Bond yields flat as investors await FOMC verdict

US: 2.71% (-1bp)

UK: 1.46% (+1bp)

Germany: 0.68% (-1bp)

France: 0.96% (-1bp)

Spain: 1.40% (-1bp)

Italy: 2.02% (+1bp)

Portugal: 1.94% (+2bp)

Greece: 3.63% (+2bp)

Japan: 0.07% -1bp)

The eurozone 10-year yield rally paused on Tuesday.

Italy sold €4.5bn 2% 2028 bonds with average yield of 2.06% versus 1.86% at 2.05% 2027 bond auction on December 28. Italian 10-year yield closed 1bp higher at 2.02% on Tuesday.

German 10-year yield eased 1bp to 1.68%, as preliminary data showed German consumer prices deflated 0.7% month-on-month in January versus -0.5% expected by analysts. Inflation stood at 0.6% a month earlier.

In contradiction with lower consumer prices, the rapid German growth is a source of fear among the economists. Capacity utilization in the manufacturing sector is at a decade high. According to Moody’s, this is “a signal that the economy is increasingly overheating”.

“Things are a bit tight in certain sectors, but overheating would mean that big wage increases were on the way, which would stoke inflation,” said Albert Braakmann, economist at Destatis, the German state statistical agency. “But [wage rises] are actually very moderate”, hence their pressure on inflation remains very much limited.

For now, lower German prices could add more downside pressure on euro-area inflation.

Eurozone estimate for inflation in January will be released on Wednesday. According to the consensus of analyst expectations, the headline inflation may have eased to 1.3% year-on-year from 1.4%y/y printed a month earlier. Core inflation may have improved to 1.0%y/y, from 0.9%y/y.

Across the Channel, the 10-year gilt yield advanced 1bp to 1.45%.

The pound recovered to $1.4184 in the overnight session.

At his speech before the Lords Economic Affairs Committee on Tuesday, the Bank of England Governor Mark Carney said that the inflation target framework remains fit for purpose. He added that the pound pass-through is still working through inflation.

In the US, the Federal Reserve’s policy verdict is the key highlight for bond investors. The Fed will likely maintain the status quo at its January meeting later on Wednesday. Yet, FOMC members are expected to deliver a more upbeat assessment on the economy and emphasize the rising inflation in the US, which should provide a stronger case for higher interest rates later this year.

According to the Fed’s latest ‘dot plot’, the benchmark Fed fund rate is projected to end this year between 2% and 2.25% range, compared with 1.25% and 1.50% presently. This means that the Fed is expected to hike rates three times during 2018.

Based on bond futures trades, the next Fed rate hike will likely occur in March, with a probability of 90.1%.

This being said, prospects of higher inflation could spur expectations of a steeper interest rate normalisation.

"We believe that the Fed may be forced to raise rates more rapidly than the market is currently anticipating due to accelerating economic conditions and a heating of the economy," said John Roberts, director of research at Hilliard Lyons.

The US 10-year treasury bond yield climbed 3bp to 2.73%, the highest level since April 2014, then corrected to 1.71%.

Whether the 10-year yield could continue rising toward 3% depends on “how much additional juice we could actually price in” said Geoffrey Yu, head of UK investment office at UBS Wealth Management.

Meanwhile, Kit Jukes, chief FX strategist at Société Générale, noted that “there is a break uncertainty about where we are traveling to” in terms of bond yields, “as opposed to just worrying about the speed we move at. This gives, at least, a temporary spike in volatility”.

He added that “if just moving to 2.72% splatters the equity market all over the floor”, central bankers could also back off, as they have done in 2013 when the 10-year yield advanced to 3%.

By Ipek Ozkardeskaya