German bunds rally, as do most assets ahead of FOMC

Rates

Yesterday, markets were in a good mood, without fearing today's FOMC meeting. Markets apparently still see central bankers as their friends who have no intention to take the punchbowl away. The US 30-yr bond auction went very well, contrary to the 3- and 10-yr auctions on Monday. It suggests that investors start to see value in the very long end after the recent yield surge. German bonds outperformed US Treasuries. Equities and peripheral bonds traded strong, while the dollar and oil ended little changed.

In a daily perspective, the US curve slightly bear flattened with yield changes varying between +2.2 bps (2-yr) and -2.2 bps (30-yr). The US 10-yr yield ended unchanged. The German yield curve bull flattened with yields up to 5.7 bps (30-yr) lower. Peripheral bonds outperformed the Bund for the second session. 10-year yield spreads declined 3/2 bps (Portugal/Spain/Ireland) to 8 bps (Italy, Unicredit). France and Belgium did well too, with a 3/4 bps narrowing. Greece bucked the trend an 11 bps spread widening, as the IMF raised bail-out doubts again.

FOMC to increase rates, but what's next?

The FOMC will increase its official rate corridor to 0.50-0.75% from 0.25%-0.5% currently, the second rate increase in this cycle and the first this year. The FOMC promised to increase rates very gradually, but the election of Donald Trump with a programme of tax cuts and extra spending, protectionism and anti-immigration changed the environment the FOMC faces the next years. Markets didn't hesitate and discounted a reflationary policy. Inflation expectations soared and so did yields. At the same time equities set new all-time highs and oil and other commodities increased (not alone due to Trump). Markets will look for hints that the FOMC will become more aggressive in 2017/18. That's what standard economics would prescribe as the cycle is ageing and inflation will increase. However, we think the FOMC won't anticipate on fiscal policy changes, but wait for more detailed plans and gauge the chances of implementation. The Fed may proceed cautiously today and confirm their 2 rate hikes in 2017 and 3 hikes in both 2018 and 2019 (dot plot). Influential NY Fed Dudley said last week: "It is premature to reach firm conclusions about what will likely occur," "As we get greater clarity over the coming year, I will update my assessment of the economic outlook and, with that, my views about the appropriate stance of monetary policy.". In such scenario, markets should react calm and this might remain the case till the end of the year with some profit taking. If the Fed drops hints that its policy will become more aggressive, the curve will (bear) steepen.

Rate hike, but unchanged dot plot?

Overnight, Asian stock markets trade mixed. Brent crude and the US Note future are nearly unchanged, but, if any, point to a slightly stronger opening for the Bund.

Today's eco calendar contains US retail sales, PPI and industrial production data but these will be overshadowed by the Fed meeting. We expect a 25 bps rate hike and an unchanged dot plot. That's discounted on rate markets and could trigger consolidation/correction higher into the year-end. A hawkish surprise (higher dots) could cause a new sell-off on the US Treasury market and force a break of key technical levels. The US 2-yr yield broke is already 1.1% resistance, but key resistance levels in the US 5-yr yield (1.85-1.9%), 10-yr yield (2.5%) and 30-yr yield (3.25%) managed to hold. We hold our sell-on-upticks approach in US Treasuries.

Last week, the ECB cemented the front end of the European yield curves for longer though we're doubt whether they cap the upward potential for long term yields. From a technical point of view, the German 30-yr yield tested key resistance (1.2% area). We watch out how the market assess the change of the guard in Italy and the endgame in the Monte dei Paschi thriller. Short term, the outcome of the Fed meeting, will also influence European rates.

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