Our medium term views

 Our key forecasts

  What we like right now

  The View

 The week that will be

  Next week will be full of data releases, allowing the market to test the potential re-acceleration narrative in the US and the strength of the disinflation trend in the Euro Area, both of which have allowed a significant outperformance of EUR vs US rates.

US data will include JOLTS and consumer confidence on Tue, advanced Q3 GDP print on Wed, PCE on Thu and most importantly, NFP on Fri, alongside ISM. Core PCE and NFP will be most relevant for the Nov FOMC decision. Our economists look for core PCE to decline to 2.6% YoY and look for NFP at 100K (cons 135K) but mainly due to hurricanes and strikes. The rest of the data will also help inform market pricing of the terminal rate and whether it has scope to extend its rise ahead of the US election, from a low of 2.7% in Sep, to 3.4% currently. We expect Treasury's refunding announcement on Wed to be uneventful and for UST to hold nominal auction sizes constant (US Rates Watch, 23-Oct).

In the EA, the focus will be on the Oct CPI prints. Our economists expect headline to rise marginally to 1.8-1.9% while core falls further to 2.6%, its lowest level since Jan-22. We will also get Q3 GDP data (BofA: 0.2%) and EC sentiment indicators, which we believe hold more information content than the PMIs. We expect a small improvement across sectors. The goldilocks narrative in the EA may thereby strengthen, supporting periphery spreads and putting steepening pressure on the curve. We hedge upside surprises in the data with payer flies, position for long-term weakness with bull flatteners, and close our US-EUR trade in payers as it hit target (European Rates Watch, 23-Oct).

In the UK, all eyes are on the budget to be presented on Wed. We expect borrowing needs to rise by £20bn, with an increased share of short-term debt allowing for long-end outperformance in conventionals and "ultra" linkers. Markets will also pay close attention to how much of the fiscal "headroom" (created by a change to the debt measure) the Chancellor plans to use in future. We remain bearish 5y real rates as reduced fiscal tightening and a growth positive budget should add to the case for cautious BoE cuts.

The BoJ will be the only central bank meeting next week. Gov Ueda's communication will likely be less dovish than in Sep, but we don't expect a strong signal for a Dec hike. The JGB market is likely to focus more on the result of the Lower House elections this Sunday. If the ruling LDP+Komeito coalition does not retain a majority, the yield curve could steepen on dovish implications for the BoJ and increased fiscal risk (Rates - JP).

In Australia, we will get the 3Q CPI print. We believe the market is priced for a 0.7-0.8% trimmed mean QoQ print. Given the recent underperformance of AU rates cross markets, the main risk would be a print of 0.6% or below (Rates - AU).

The week that was

The week saw a flurry of central bank speakers around the IMF meetings. The tone from the ECB was decidedly dovish, with several speakers flagging the possibly of cuts to below neutral and/or a 50bp move in Dec should data worsen. BoE speakers on the other hand have highlighted risks of inflation persistence, which, alongside reports of changing the debt measure, supported renewed underperformance of Gilts cross markets.

The BoC cut rates by 50bp, in line with market pricing. In a shift vs September, the BoC now see risks around inflation as "reasonably balanced". CAD rates closed slightly higher and the gap between 3y1y CAD and EUR OIS widened further. This is a cross market trade we still hold, targeting 80bp (the main short-term risk being stronger EA data).

Funding pressures were also at the center of price action this week, especially in EUR, where the cheapening of term repo, combined with larger than expected supply caused a significant tightening in swap spreads. We update our regression analysis in Rates - EU.

  Rates - US

•      The pop in rates in October was mostly about a Fed pivot and good data
• Election sweeps are bear steepening risk; we like buying dips esp on mixed govt

 Dodging Yankee risks

US rates sold off again this week led by the belly. Driving the move was continued shifts in views on the Fed cutting trough, perceived shifts in election probabilities from betting markets, and reduction of overweight longs (esp. from CTAs, see positioning report).

We sense light fixed income risk taking from real money investors ahead of key US risk events. Next week will see tier 1 US data (Tu=JOLTs, W=ADP, Th=PCE, F=NFP & ISM manu), the UST refunding (we expect no change in auction sizes, see UST refunding), & Halloween large UST coupon settlements ($89b) + Canadian fiscal year end (which risk repo pressure, see Funding notes & marvel at tighter funding). The following week sees the US election & Nov FOMC. It's a spooky time for a rates investor.

Rates investors must dodge key US risk events in the weeks ahead. We think owning TY basis is a good value way to trade risk events in the weeks ahead (see buy Dec TY basis).

US macro: good data + Fed pivot = last +20bp

Clients have recently asked how we make sense of the recent sharp rate rise. Our attribution analysis shows that rates have largely moved with data surprises this year - with additional contributions from elections/news and the Fed. The October selloff appears to break into 2 parts: the 1^st half the month reflects the "Trump trade" which appears in our attribution analysis as "news" but then the last +20bp from 4% 10y was data and the Fed, rather than election-related news. Since mid-October Fedspeak looks like half the rate move, as the Fed has shifted to a more cautious and measured outlook for cuts, in stark contrast to the 50bp-per-meeting approach that markets had initially gleaned from the September 18^th FOMC meeting. This cautious Fed sentiment is also reflected in our revised house call for the November Fed meeting from 50 to 25bp cut.

The hawkish mini-pivot is visible in the OIS swaps and fed funds futures markets. Markets have taken out nearly half the Fed cuts priced for Nov and Dec over the course of the last month. In late Sept, markets were pricing 3.2 Fed cuts (ie 80bp of cuts) for the last 2 meetings of the year. Today the market has reduced that to 1.7 cuts (43bp). In addition, the market decreased the total number of cuts expected over the entire cycle.

On Sep 30^th, the market priced the Fed to cut down to 3% (using 3y1m OIS rate as a proxy). Today that level is 3.45%. The rise in "terminal" this month is almost exactly matched by the rise in 10y rates, which is mainly a function of terminal rather than the specific cutting path that brings us to terminal.

A higher terminal reflects surprisingly strong jobs, inflation and spending, with Thursday's initial jobless claims showing almost a complete reversal of the worrying rise in claims from Jan through July. We view initial jobless claims as a strong leading indicator for the unemployment rate across cycles and it is not indicating any widespread layoffs. Rising continuing claims suggest that it takes longer to find a job if fired or entering the labor market. On net, the labor market appears to be moving into better balance & not showing overly worrisome signals, driving the Fed re-pricing.

Duration dipper: we continue to encourage clients to buy the rate dip. We have argued for trading US duration tactically, believing near-term 10Y range will be 3.5-4.25%. We think it makes sense to tactically add duration exposure towards upper end of the range; our preferred duration point remains the belly (5Y). Our dip buying approach is based on the view that the Fed will not pivot again to hikes but will remain in cautious cutting mode for much of 2025, looking for opportunities to deliver a policy stance more aligned with the lower level of inflation risk.

Core PCE is 2.7%, down from nearly 6% in fall 2022 (our economists expect a similar print next week, see PCE tracking). If core PCE stays below 3%, we think the Fed will seek to normalize policy into at least the low 4s (3 more 25bp cuts would deliver effective fed funds at 4.08%). We think it will be difficult for markets to price less cuts than 3, even if jobs and spending remain robust - as long as inflation remains below 3%. In worst case scenario for bonds, if markets price only 3 cuts instead of 5.6 current, it would likely increase 10y rates by about 50bp to around 4.75%. Using this approach to ballpark the worst case, we think buying dips at 4.25% and higher would be a reasonable strategy, as long as inflation remains stable or lower which we think is likely.

Election dip could be a good buying opportunity

Many clients appear uncertain & light risk ahead of the US election. We elaborated on our election views in US rates and election FAQ. Clients indicate limited willingness to trade the US election given in our polling (see Sentiment Survey). Global benchmark investors still have conviction in long duration but have rotated in part out of US duration in favor of EA duration. Domestic benchmark investors, based on our regression framework, have been buying the dip (see: Longs vulnerable to covering).

We see evidence of dip buying as well in IG corporates, which at an 83bp IG Index spread to Treasuries, is near all-time tights both on an absolute basis and relative to the level of 10y yields. But the 1^st week of November offers large tail risks that could provide opportunities to buy. We like buying dips in the scenario of a mixed government, where more than one party controls Congress and the Presidency. Sweep outcomes can result in larger selloffs that will likely take greater conviction to buy. Heading into the election we prefer expressions like long TY futures basis for a low cost option on materially higher rates and a steeper curve & holding longer-dated short swap spread position as way to position for rising fiscal concerns.

Bottom line: Early November with the US election, payrolls, Fed and refunding presents risk for long duration positions, particularly at the back end of the curve. Sweep outcomes likely to see market trade higher back-end yields on supply & fiscal concerns. We prefer to express this risk through short 30y spreads. Medium term, think that an election-related selloff would present a dip buying opportunity and real rates could be more compelling if inflation becomes an issue with higher tariff policies. We believe that the market will struggle to price less than 3 Fed cuts for the remaining cycle even in big selloff scenarios as inflation risk is generally lower and the Fed would still be restrictive at 4%.

  Rates - EU

• We modify our swap spread regressions to better account for ECB QT, term funding pressures and collateral dynamics, and find Schatz being marginally rich vs swaps.
• We draw three lines of support for German spreads vs Euribor and believe they are likely to stay in positive territory, although year-end can be a challenge.

Swap spreads: in search of support

Interest on EUR swap spreads grew as German bonds cheapened back to pre-QE levels with Schatz spreads to €str turning negative. Clients question whether German spreads may follow UST spreads into heavily negative levels (Exhibit 5). The case for tighter spreads near term boils down to three factors:

1. Repo cheapening driven by declining liquidity, growing demand to fund long bond positions, and, more recently, funding pressures into year-end (see Front-end EU)
2. Risk-on environment with lower implied vol and tighter periphery spreads
3. Record net supply: EGB supply net of redemptions, coupons, buybacks, and ECB QT is expected rise to a new record in 2025 at c. €660bn, from €590bn in 2024

Accounting for QT and collateral supply

The German spread regressions we used in recent years have persistently suggested bonds are cheap since the end of 2023. We believe the regressions may not be capturing enough the impact of ECB QT and/or market perception of present and future collateral supply. To address this, we updated the details of the regression a few weeks back (Global Rates Weekly, 20-Sep) and add a change now to account for term funding:

• We keep the following variables: 3M implied vol, 1^st principal component of periphery spreads, the 1-day German specific collateral repo (SC) spread to General Collateral (GC) and the 1-day German GC-€str spread.
• We Introduce the 3M German general collateral repo (GC) spread to €str instead of one-day German GC-€str from Mar-23, when ECB QT started.

The resulting coefficients from the modified regression are in Exhibit 6, using data since May-18. The latest residuals point to Schatz being marginally rich vs swaps, Bobl close to fair, and Bund cheap (Exhibit 7). We were long Schatz spreads as a risk off hedge and were stopped out of the trade at the end of last week, but the large cheapening could be enticing some investors to consider this risk-off hedge, supporting Schatz vs Bunds.

For 30y spreads, we use the level of rates instead of vol as variable and consider a shorter period (past 3y) given the different structural changes that have occurred in terms of receiving flows in the back of the curve between 2018 and 2020. As expected from the traditional dynamic hedging flows from Dutch Pension Funds, we find that 30y spreads tend to tighten when rates rise. That said, we expect the Dutch pension reform to drive receiving (and thereby Buxl cheapening vs swaps) even in rallies for the near term. The traditional range trading in Buxl spreads by other P&I that could however provide support at the current c.-30bp level, following the sharp c.10bp tightening.

Three theoretical lines of support for Euribor-based swap spreads

Using our modified regressions, we believe there are two key German GC-€str levels for Euribor-based swap spreads. We also believe capital requirements act as the ultimate backstop from banks leveraging to buy swap spreads. Assuming all other variables being equal, this creates three lines of support for 6M Euribor-based swap spreads:

• German one-day GC = €str + c. 15bp. The ECB lends at the refi rate, which is currently €str + c. 25bp, against all eligible collateral type, although haircuts vary. We believe the first key German GC-€str spread level will be slightly below the refi rate if the market feels the need to further account for collateral credit differences. If we were to also apply this level to 3M GC-€str, this would imply a Schatz invoice spread at c.9bp and Bund spread at 11bp.
• German one-day GC = €str + c. 25bp. The refi rate is the theoretical cap on German GC. In the absence of stigma and collateral constraints, banks will shift funding to the central bank once market funding rates exceed that from the ECB. This would imply Schatz and Bund spreads at c.5bp if only 1-day GC = €str+25, with 3m GC at €str+15bp, and spreads of -10 and -6bp resp. if 3m GC is at €str+25bp.
• Capital requirements. Under current market rates, we estimate a euro area bank targeting a RoE of 10% and leverage ratio of 5% can justify additional capital usage to go long German swap spreads from an only-carry perspective if the Bund and Schatz spread are c.-50bp or lower, but a lower RoE target given the low risk in German bonds would reduce the bar, providing earlier support (Exhibit 8).

To the extent German one-day GC is unlikely to cheapen persistently beyond €str+25bp, we believe swap spreads vs 6s would therefore likely stay in positive territory, with the most challenging period being the current one, when term funding can cheapen further.

   Rates - UK

•  We continue to estimate a GFR increase of £20bn for FY2024-25, financed by £5bn more T-bills and £15bn more Gilts, with a small skew shorter.

 Bills through the letterbox

 Public finances so far this year: slightly good news in September

This week's release of public sector finances data - an early but increasingly reliable indication on the state of the public finances for the whole year - delivered a Central Government Net Cash Requirement (CGNCR), which forms the basis for Gilt issuance, of £13.2bn versus the Office for Budget Responsibility's (OBR) forecast of £15.9bn. Cumulatively, the overshoot in the first six months of the fiscal year stood at £14.1bn as of September, a decrease of £2.7bn from the month prior (Exhibit 9). Our updated projections assume no further deterioration or improvement in the CGNCR, relative to March OBR numbers, over the balance of the fiscal year, and assume the original NS&I target is unchanged in the Remit update (Exhibit 10).

Final look at the DMO Financing Remit 2024-25 update

The DMO will publish an update to its Financing Remit for the fiscal year 2024-25 alongside the Budget on 30 October. We continue to estimate the GFR to amount to £162.8bn, an increase of £20bn relative to April's Remit. Our expected change in GFR stems from: (1) a £14.1bn CGNCR overshoot versus the OBR March forecast as of September; and (2) around £10bn Chancellor plans and commitments. We expect these increases to be partially offset by (3) a reduction of about £3bn in CGNCR because of the lower than previously projected capital transfers from the Treasury to the Asset Purchase Facility (APF), due to lower-than-projected active Gilt sales from October.

Given our current expectation for the DMO to raise an additional £20bn relative to April's Remit, we stick to £5bn as our base case for net T-bill target for debt financing purposes. A higher-than expected GFR could command more T-bills, in our view. Our current expectation for additional £15bn of Gilts to be added on 30 October and distribution of the "unallocated" imply the share of short-dated Gilts increasing to 38% (+2% relative to March/April); the share of medium-dated Gilts rising to 32% (+1% relative to March/April); the share of long-dated Gilts rising to 19% (+1% relative to March/April); and the share of linkers staying unchanged at 11% - Exhibit 11.

From our recent conversations with market participants, £15-20bn in additional Gilt issuance is where many draw a line between "tolerable" and "too much" for 30 October Gilt Remit update. The general consensus seems to be for a skew shorter (ranging from small to more substantial); a lesser skew shorter from the DMO (perhaps in a scenario where the DMO both tops up the long Gilt syndication allowance and adds to the long Gilt auction plan) would be a risk to this seemingly consensus view.

Heading into the Budget, we (1) remain bearish real yields in the UK outright and cross-market; (2) continue to expect long-end performance, in conventionals and "ultra" linkers; (3) remain bullish on low coupon vs. high coupon Gilts:

• Pay 5y real Sonia, rec 5y real Estr (Liquid Insight, 21 Aug). Entry: 43bp. Target: -40bp. Stop: 90bp. Spot: 33.7bp. Risk: UK recessionary threat.
• Pay 5y real Sonia (UK Rates Alpha, 12 Jul). Entry: 1bp. Target: +60bp. Stop: -30bp. Spot: -11.9bp. Risk: Recessionary threat.
• Sell UKT 4.5% 2028 vs. 0.5% 2029 on ASW (Back to school: tough tests this term, 5 Sep). Entry: -8bp. Target: -20bp. Stop: 4bp. Spot: -14bp. Risk: Change in UKT tax treatment for retail.
• Buy UKT 4 3/8 07/31/2054 vs. T 4 5/8 05/15/54 on ASW (Spotlight on cross-market spreads, 12 Jul). Entry: 1bp. Target: -15bp. Stop: 10bp. Spot: 2.3bp. Risk: Large increase in DMO long Gilt supply from "unallocated".
• Buy UKT 0.625% 2050 vs. 4.625% 2034 on ASW (It's going to be a bumpy ride, 7 Jun). Entry: 33.5bp. Target: 13bp. Stop: 45bp. Spot: 23.2bp. Risk: Large "unallocated" shift to longs.

• UKTi 2052/68 yield flattener ("Ultra" linkers - Unloved Long-Term Real Assets? Time to reevaluate, 20 Feb). Entry: -13bp. Target: -35bp. Stop: 0bp. Spot: -16bp. Risk: Illiquid market conditions.

  Rates - AU

•  AU underlying CPI to print in line with RBA expectations next week, in our view.
• Positioning has exaggerated the sell-off in AU rates and the long end now looks too cheap.
• …but the US election potentially presents a binary outcome. We prefer to wait until after November 5 to add risk.

We expect another quarter of solid price momentum

The Australian Bureau of Statistics is set to release the 3Q CPI report next week. We look for headline CPI to come in at just 0.4% qoq, a notable slowdown from the 1.0% in the previous quarter, on the back of electricity rebates. For the RBA, the most important print is likely to be trimmed-mean CPI. We anticipate trimmed mean inflation likely stayed elevated at 0.8% qoq. This would leave the %yoy rate for headline and trimmed-mean CPI inflation at 3.0% and 3.5%, respectively.

What is priced?

The market is fully priced for a 0.7-0.8% trimmed mean CPI (QoQ) print, in our view. The risk scenarios would be if inflation printed at 0.6% or below. If trimmed mean CPI prints at 0.9% or above, we think the market could price some probability of a hike over the next few meetings.

Cross-market longs have been squeezed

We think cross-market longs would make sense at this level, particularly in the 3y-10y sector, given how wide the rate differentials between the US and Australia have moved. Although 5s10s swaps curves have shifted steeper in the US than Australia (Exhibit 13), capping the increase in 5y5y yields on a cross-market basis, 10y rates have underperformed as US election-led repricing in the long end, which is unusual (Exhibit 12). Part of the reason for this underperformance is that recent AU data has been strong (unemployment unexpectedly fell in last week's print).

Positioning has exaggerated these moves

We suspect positioning is the main reason for this underperformance: investors have generally been telling us they are long AU duration on a cross-market basis because of the unusual steepness of the AU curve. 5y5y cross-market longs are particularly popular and have not performed as badly as 10y cross-market longs but levels are nevertheless quite wide. Strong economic data has likely led a repricing of terminal rates in the US, contributing to US-led steepening Hedging long duration positions with short RBA positions could make sense but investors would need to trim their risk before the US election.

… but beware binary risks into the US election

Absent an election catalyst, we would recommend longs at this level but positioning for a Republican victory in the US presidential election means the outcome of the election is now probably quite binary for AU rates: if Harris wins, the curve probably bull flattens as crowded bear flatteners unwind. If Trump wins, the curve likely bear steepens further as the probable outcome becomes a certainty. Admittedly, this is a contested view in our meetings with investors. Just as political risk premium in the FX market is elusive, it is also difficult to disentangle the effects of strong US economic data from political risk premia in the United States. In any case, vol pricing suggests wide moves are likely post-election so some caution is warranted.

Bumpy road ahead for inflation to return to target

Recent data has been mixed. Leading indicators have suggested disinflation has accelerated and consumer inflation expectations moderated to 4% in October, the lowest reading since August 2021 (Exhibit 14). On the flipside, employment growth surprised to the upside for the seventh time this year in September, with 64k jobs added in the month. We also do not know whether recent fiscal stimulus will lead to a meaningful pick up in domestic demand, which could make inflation's return to target more gradual than expected.

Headline affected by subsidies, rents have held up

Monthly CPI data suggested that rents continued to increase by a strong 0.6%mom in both July and August, which was just a slight moderation from the average rate of 0.7% mom in 1H 2024 (Exhibit 15). Moreover, the Commonwealth Rent Assistance program only took effect on 20 Sep 2024 so the relief to the September rents reading would be fairly limited. National Energy Bill Relief came into effect in July 2024. As a result, the electricity component of monthly CPI showed steep declines of -6.4% mom in July and -14.6% mom in August, compared with 0.1% mom gain in June. We also estimate that energy components combined dragged down the %qoq of headline CPI inflation by 30bp.

   Rates - JP

•  Lower House elections will be held Sunday, 27 Oct. Focus is on whether the ruling LDP+Komeito coalition can retain majority.
• Scenarios where the LDP loses its power imply steepening of the JGB yield curve on dovish implications for the BoJ's policy and increased fiscal risk.

Japan headed to the polls on 27 October

Japan will hold Lower House elections on Sunday, 27 October. All 465 seats will be up for grabs, with 289 elected through single member districts (SMDs), and the remaining 176 through proportional representation (PR) in 11 regional blocs. Exit polls are released shortly after voting ends (8pm local), and we should get a good sense of the outcome by midnight or so.

Limited impact on policy if ruling coalition = majority

Exhibit 16 summarizes the four possible election scenarios, and their implications for policy. If the LDP falls short of a single majority but retains a majority with its coalition partner Komeito, the impact on monetary policy will likely be limited: the BoJ would remain on track for another hike in the coming months (our base case is January). On fiscal policy, we see the risk of a slightly bigger post-election economic package / supplementary budget, given the potential for Komeito's increased influence in the ruling coalition. But the degree of fiscal easing is unlikely to be a game changer.

How will political uncertainty impact the market?

As we wrote above, various opinion polls suggest LDP may lose some seats in this election while no other parties could emerge as a clear winner. As a result, any emerging government is unlikely to be more stable than the current coalition has been in the past decade with the LDP the dominant force in the parliament.

Political uncertainty can also make the BoJ more cautious in conducting monetary policy at the margin. As rate hikes can impact various segments of the economy in different ways, the BoJ would want the government to be supportive of its policy.

All in all, we think increased political uncertainty can be negative for the yen-if risk-off in Japanese equities leads to knee-jerk strength in JPY, we would fade it. Meanwhile, scenarios where the LDP loses its power imply steepening of the JGB yield curve on dovish implications for the BoJ's policy and increased fiscal risk.

Would any party attempt to interfere with BoJ policy?

We do not expect any party would proactively interfere with BoJ policy. The point in focus is the CDPJ, the main opposition party. It calls for amending the accord between the government and the BoJ to set a new joint objective on real income growth, in addition to the price stability target. It also calls for a change in the BoJ's price stability target from 2% to "above 0%". Some market participants view it as positive for JPY as it would lead to faster rate hikes to contain inflation.

However, we are skeptical about this view. First, key CDPJ members have clarified that positive real income growth would be the primary objective. They note the inflation rate can be 2% and their intention of the proposed change in the price stability target is to increase policy flexibility. Second, a government led by the CDPJ, if realized, is unlikely to be more stable than an LDP-led government. Based on recent polls, in case the coalition loses its simple majority, it would still be by a narrow margin. As the Upper House election is scheduled for Jul 2025, controversial policies may not be implemented easily.

Finally, while the CDPJ calls for fiscal discipline over the long-term, it focuses on spending measures to support households. On this point, no party is calling for fiscal consolidation. The major parties' manifestos focus on spending and tax cuts without discussing revenue. Japan's fiscal condition is unlikely to improve under any government in the near term. This may limit the scope and the speed of the BoJ's rate hikes.

Implications - election unlikely to be game changer for JPY & JGB

We have been bearish on JPY and expected JGB yields to rise but gradually. One key risk against our view is faster BoJ policy normalization. However, as we discussed above, Japan's general election on Oct 27 is unlikely to lead to a more hawkish BoJ as political uncertainty is likely to remain elevated after the election, and given the lack of strong political will for monetary policy tightening.

 Rates - CA

•  The BoC cut its policy rate by 50bp to 3.75% this week. Policy divergence between the BoC and Fed has led to the widest 10y rate differential on record

USD-CAD rate differential widest on record

The Bank of Canada (BoC) cut its policy rate target by 50bp on October 23, as expected by consensus, to put the rate at 3.75% (E. 3.75%, BofA 4.00%). It continues to normalize its balance sheet. In the post-BoC decision press conference, Governor Tiff Macklem said their focus is on keeping inflation close to 2.0% and that further cuts should be expected if economic conditions evolve broadly in line with their projections.

The BoC's 50bp cut initially led CAD front-end rates lower and the 2s10s curve steeper on the day before largely reversing during the press conference. Markets are now pricing in a roughly 50% likelihood of a 50bp cut at the Dec BOC meeting.

Expectations of the BoC terminal rate, as determined by CAD 3y1y fwd swaps, imply a BoC terminal of 2.8%, in line with BoC's estimate of neutral between 2.25-3.25%. The divergence between central bank policy expectations in recent weeks have led expectations of their respective terminals to widen from a low of 49bp in early Oct to 72bps.

The main contributor to this divergence in policy expectations has been the data. The US is not currently showing definitive signs of slowing - with jobs, spending, and inflation all tracking above our forecasts - while Canada shows clearer signs of slack and softening price pressures resulting in part from the impact of higher rates on consumers. This has been a large driver of the difference in performance between US and CA 10y rates which are now at their widest rate differential on record at 99bps (Exhibit 17). If the BoC continues to cut in line with where markets are pricing, this should continue to be the catalyst for a wider USD-CAD rate differential in the long-end of the curve.

  Front end - US

• Logan was hawkish on the balance sheet & implicitly expects tighter funding conditions & cheaper USTs

Logan joins X-members of tighter Fed balance sheet club

Dallas Fed President Logan's Oct 21 SIFMA speech was hawkish on the Fed balance sheet & funding. The speech reinforced our view to trade spreads from the short side across tenors (our preferred short remains 30Y). Logan's speech also suggests funding to tighten into year-end & see higher dealer intermediation costs. Our takeaways below.

Hawkish Logan: USTs should cheapen

Logan's more hawkish funding comments included (1) money market "liquidity appears to be more than ample" (2) "important to tolerate normal, modest, temporary pressures" on money markets to shrink balance sheet. Logan's ample liquidity views stem from low TGCR & FF rates vs IORB. Logan placed less weight on the recent sensitivity of SOFR at quarter end or collateral settlement dates (see Funding notes).

Logan believes that low TGCR but higher SOFR reflect dealer intermediation constraints. These constraints will likely increase with higher UST supply & regulations. To us, Logan suggests funding should rise with higher UST supply. Our take: stay short spreads.

Fed repo clearing: helpful but don't hold breath

Logan flagged the possibility of Fed repo clearing, which she has mentioned in the past. Fed repo clearing would help dealers net down balance sheet exposures (dealers could net down repo cash borrow from Fed and repo cash lending if done via clearing CCP).

Fed repo clearing would help improve cash movement but it is unlikely to occur anytime soon. We see 2 key hurdles: (1) Fed counterparty risk considerations; i.e. Fed is inherently counterparty risk averse and it will take time to be comfortable with central CCP exposures (2) CCP haircuts; we doubt the Fed would be willing to pay CCP margin, which means end users would likely need to pay higher margin requirements.

We expect a long runway for any Fed repo clearing (see Funding remedies). We might guess it could take 2Y+ to implement (Fed minutes flagged repo clearing in '21). Even if Fed clearing were to take place, cheaper USTs likely needed with margin considerations.

Bank liquidity demands: higher than you might think

Logan was hawkish on bank liquidity needs. She said: "it's unlikely bank liquidity demand has nearly doubled in half a decade." Banks have increased cash / asset holdings from <10%% in mid / late '19 to 13.7% today. We wouldn't be so quick to dismiss.

We believe bank liquidity needs have increased due to a variety of factors that impact their internal liquidity stress tests. Higher cash buffer drivers include: (1) protection against need to sell underwater securities holdings (2) higher uninsured deposit outflow risks, especially post SVB (3) deposit stability concerns with higher money market rates. Banks have clearly paid up via large time deposits to offset their sluggish retail deposit growth. Banks are likely only paying up via large time deposits because they want the liquidity (see Banks fighting to keep liquidity).

          Front-end - EU

• Year-end euro funding activities picked up as balance sheet pressures at the forefront and exacerbated by global long bond positioning
• Cross-market opportunities still limited and we are slightly biased for basis widening into y/e

2024 year-end turn in EUR #2: terming up

The EUR-USD xccy bases reached post risk-free rate reform record tights. For the 2024 y/e turn, the EUR FX-Sofr basis tightened from c. -370bp to c. -200bp in over a week (Exhibit 18). We believe this was driven by structural views on US dollar vs euro liquidity, views on euro funding needs, and possible stop-losses on existing receive basis positions. The tightening momentum paused on 21 October after Dallas Fed President Logan was hawkish on the Fed's balance sheet (see our report: US Rates Watch, 22 October 2024).

Since the 3Q24 q/e turn, 3M GC-€str cheapened as investors began to secure funding of bonds over y/e: the 3M Germany GC-€str spread exceeded the one-day tenor (Exhibit 19). The market is pricing in Germany GC-€str over the y/e turn at €str + c. 60bp, from €str + c. 30bp over a week ago, which would be its highest since at least 2013 (Exhibit 20).

In the euro market, 1) low usage of sponsored repo, and 2) the small MMF industry (when compared with the US) mean funding of long bond positions by leveraged investors will increase dealers' exposure and the associated regulatory requirements. Data continue to signal leveraged investors' cash demand in euro repo has grown. In 1H 2024, HFs net purchased €14bn of German Government securities and this was the fifth consecutive semi-annual net increase (Exhibit 21).

In recent years, leveraged investors' short euro bond positions and long US bond positions allowed dealers to net the associated repo transactions from their exposure calculations. But leveraged investors are now net long euro bonds and USTs (Exhibit 22, see our: US Rates Watch, 21 October 2024). The decline in netting opportunities for dealers further limits their financial intermediation capacity.

 For dollar-based investors, potential gains from recent cheapening in euro rates were offset by the tighter EUR FX-Sofr basis. Front-end US repo and T-bills still offer slightly higher FX-hedged pickups over German equivalents (Exhibit 23). But the current low pickup levels in front-end US vs euro rates suggest any cross-market flows may not be large enough to create meaningful widening pressures on EUR FX-Sofr basis.

The tight funding outlook in both euros and US dollars will keep uncertainty high over the EUR FX-Sofr basis into y/e. On balance, we are slightly biased for EUR FX-Sofr basis widening into y/e as the market further digests the liquidity implications of Logan's recent speech and as a risk-off hedge.

  Supply - US

• Expect Nov refunding announcement to be uneventful and for UST to hold nominal auction sizes constant

Expect no changes in nominal auction sizes

We expect the November refunding announcement to be relatively uneventful and for UST to hold nominal auction sizes constant. In our baseline deficit forecasts, we have nominal coupon auction sizes holdings steady at least through FY '25. As we discuss in greater detail below, while we are confident that UST will need to grow supply again at some point, timing and extent of increases will depend on 1/ UST's tolerance for bill supply > 20%, 2/ deficits & election outcomes. UST is unlikely to provide meaningful guidance on timing or extent of future coupon supply growth at this refunding especially ahead of potential administration change.

Coupon increase timing depends on bill supply tolerance

At the last refunding, TBAC updated its guidance on bills as % of portfolio from 15-20% to "averaging around 20% over time." This shift skews risks later for future coupon size increases which will depend on UST's tolerance around 20%. We think that 22.5% is a rough proxy for how high UST may want to see bill supply run. Our baseline scenario for deficit does not see bills above 22.5% until the end of FY '26.

Extent of coupon increases will be election dependent

As discussed in US Elections: The Great Debates, we expect a higher fiscal deficit in either Democrat or Republican sweep scenario. The composition of incremental deficit would likely vary between higher spending (Democratic sweep) or lower taxes (Republican sweep). We anticipate deficit widening sees the largest risk under a Republican sweep due to the full extension of the Tax Cuts and Jobs Act which CBO suggests would cost about $4.5tn over 10 years. Even under sweep outcomes however, the deficit impact is unlikely to be consequential until FY '26, which limits the scope of coupon size increases for the next few quarters.

Anticipate final increase in TIPS for now

Consistent with TBAC financing recommendations, we pencil in an additional $1bn increase to the 10y TIPS new issue over the November quarter. After these recent increases, we see TIPS as a share of supply ex-bills stabilizing, assuming unchanged nominal coupon auction sizes. We assume that this will be the final TIPS increase and expect UST to hold off adding until nominal coupon supply grows again.

Bottom line:  We expect the November refunding announcement to be relatively uneventful and for UST to hold nominal auction sizes constant. We believe that UST will continue to grow 10y TIPS new issue by $1bn this quarter, but likely to pause further growth until broader nominal supply increases. In our baseline deficit forecasts, we have nominal coupon auction sizes holdings steady at least through FY '25. Timing and extent of increases will depend on 1/ UST's tolerance for bill supply > 20%, 2/ deficits & election outcomes.

  Spreads - EU

•  The meetings in Athens struggled to find negative catalysts for GGBs
• The country displays the most aggressive adjustment in Debt/GDP and short-term growth and technical dynamics remain good enough for further GGB tightening

GGBs: straight path to improvement

We update our outlook on Greek government bonds following last week's investor field trip in Athens meeting the main institutional actors and local banks.

Greek public debt fundamentals continue on the path of improvement, especially on the side of public debt in both stock and flow terms. What is notable is that the commitment to sustainable public financial balances is not only the result of a certain party's ideology but seems to be engrained in electoral demand, making this a persistent feature of Greek politics. Or at least this is the impression from this field trip.

Fundamentals improve further

Impressions aside, Debt/GDP and deficit forecasts from Greek and international watchers confirm the same picture.

When it comes to GGBs, the bulk of the discussion was around how far can the tightening go, and is it over. We think GGB outperformance has more to go.

If this trend continues, Greece should be on track to further rating upgrades, potentially surpassing that of Italy. While we do not think that GGBs should or will trade like PGBs, the positive narrative around short-term technical should imply GGBs trading richer than suggested by its credit rating (Exhibit 24) and testing 70bp vs Bunds at unchanged market risk propensity.

The rating framework does indeed suggest tighter GGBs fundamentally but slow moving variables such as relative economic gearing towards low productivity sectors (agriculture, tourism) and low performing judicial and institutional sectors (i.e. the variables comprising the World Bank Government Effectiveness Indicator, and the likes) means to us that the promotion to the A rating category likely requires more structural reforms, and more time. We think that the short-term outlook for GGBs justifies them trading richer than implied by their credit rating but likely stopping short of Bonos' level.

Supply picture is very benign and the treasury has options

The high primary budget surplus along with the high cash reserves means that the Greek treasury can remain opportunistic when it comes to issuance of GGBs. The target for next year may likely be closer to the €8bn mark, rather than the €10bn.

We have the same view as the Greek treasury on one aspect: increasing supply here for Greece is likely beneficial. The resulting increase in market liquidity likely outweighs the negative

Demand/positioning: picture, again, remains supportive

GGBs are the asset class that is most impacted by the deceleration (to zero) of ECB's PEPP reinvestments next year (European Central Bank, Pandemic Emergency Purchase Programme). This turns to what we estimate to be around €1.2bn in reduced demand relative to 2024.

On the other hand, the continuation of the rebalancing towards GGBs from passive investors and the likes is estimated in the order of €4-5bn by the treasury, assumption that we do not find unreasonable.

The decade of Greek re-adjustment and the low debt outstanding that is held by privates implies a solid and resilient demand picture for GGBs. The presence of a more complete yield curve can also accommodate demand from investor types different from banks and fast money, which the GGB market likely needs.

Furthermore, if the level of EUR rates falls below the neutral rate (between 1-2%) as hypothesised by an increasing number of ECB officials, the increased marginal demand from the "reach for yield" argument likely applies to GGBs too. But as opposed to Italy's case, such demand may impact GGBs more given the small size of the market (and the medium-term fundamental outlook).

Risks are mainly external

All in all, risks to GGBs are more likely to come from outside than from Greece. This means that the short case for GGBs likely has to mainly rely on the general risk sentiment shifting from the currently very complacent levels or from the potential spillovers from geopolitical risks expanding from the middle east.

While the latter is a risk that is very difficult to forecast the former may matter less for GGBs than it used to. In fact, we recently noted that, on a high frequency basis, GGBs are less sensitive to changing global risk factors than, for example, BTPs (see Liquid Insight: EGB spreads into year-end 04 September 2024).

  Inflation - UK

•  Retail interest seems to be increasing the "coupon effect" in nominals. We expect retail to develop a taste for linkers and look for trades that might benefit.

(Re)tail risks

The appeal of low coupon Gilt issues for taxed retail investors is easy to understand, and a richening of low coupon issues has been observable. It's just hard to infer causation from the official statistics. Data for 2Q show UK households held a trivial £3.2bn Gilts in direct form - less than 0.2% of the market and down from £5.0bn a year earlier. Retail demand for low coupon Gilts seems to be everywhere, except in the numbers. This is puzzling and makes us question those numbers, wondering whether retail is holding Gilts directly on platforms and accounts that the official statistics might not be capturing.

In late 2022, we wrote about low coupon Gilts' tax advantages for retail (see: 'Will retail discover Gilts? A little bit complicated maybe, but not too taxing', 10 November). Retail investors are taxed on income only, making lower coupon Gilts more tax efficient for taxed investors holding them directly (rather than in a fund). An investor paying 40% tax buying a 1/8% coupon issue would pay only 5bp of income tax per annum, as we understand it (we emphasise that we are not tax experts and only discuss this as a potential influence on the market).

Our latest expression of the sell high/buy low (coupon) theme in nominal Gilts was introduced last month (see: 'UK Rates Viewpoint', 5 September), where we recommended selling UKT4.5% 2028 to buy UKT0.5% 2029 at -8bp on a spread of z-spreads basis, targeting -20bp, with a stop -loss of +4bp (currently -14bp). Risk to the trade is change in the tax treatment of Gilts for retail.

What has this got to do with linkers? Well, they're all low coupon Gilts

Back in 2022, when we wrote the original note, there were four nominals with 1/8% coupons and now there are only two. We believe that the richening of low coupon issues might have as much to do with shrinking supply as with growing demand.

And this is where linkers come in. In the 1990s, when the retail share of the market was still small but much greater than it is now (typically 2-3% of the market), the financial press would print tables of after-tax nominal and linker Gilt yields together with net-of-tax breakeven rates. These concepts, which might seem strange and complicated now, were grasped by retail then. Investors understood the simple premise that the inflation uplift was effectively untaxed, giving linkers a material advantage over nominals.

This could take some time

In the nominal curve, Exhibit 26 shows increasing yield dispersion moving shorter on the curve into in the 0-5y segment but not beyond 5-years. Some dispersion has existed for a while, reflecting high Bank of England ownership of certain issues and related specialness. But now we would attribute dispersion more to the "coupon effect". Our choice of UKT0.5% 2029 for the long issue in the nominal coupon switch above reflects the belief that it will benefit as it slides into the widening "funnel of coupon dispersion", and also the likelihood that these coupon effects will push farther out on the curve.

In linkers, we want a high coupon/low coupon trade further out on the curve, where linkers' coupon advantage over nominals is greater. The appeal of longer linkers is the steepness of the after-tax real yield curve (Exhibit 27), even accepting that some of this steepness is an optical illusion, reflecting 2030 RPI reform.

There is a common perception that retail is only interested in short-dated Gilts, and this is reinforced by the fact that coupon effects are thus far only observable sub-5y in nominals. But this wasn't the case in the 1980s and 1990s, when coupon dispersion was huge (the highest being 15.5% 1998). We would contend that if retail is starting to develop an appetite for low coupon Gilts - which might be spurred by Budget measures restricting existing tax advantages of various savings vehicles - then as it grows, it will move out along the curve.

But all of this might take time (or it might happen at all), so we want a high coupon/low coupon linker switch that stacks up on other arguments.

The UKTI 1 1/8% 2037/UKTI 1/8% 2039 real yield flattener

UKTI 1/8% 2039 has an optically appealing yield, at 1.05% gross and 1.00% net at 40% tax. The yield pick-up versus 2037s is 17bp gross and 56bp net at 40%. We also have a real curve flattening bias, given our bearishness of 5y real yields on the view that the Bank will need tighter real policy rates than priced in order to check inflation. This makes the trade attractive regardless of the way the coupon story evolves.

We recommend switching UKTi 2037s into UKTi 2039s, picking up 17bp, setting a target of 9bp and a stop-loss at 25bp. Risk to the trade is idiosyncratic steepening relating to November's linker syndication.

 Rates Alpha trade recommendations