England is boring, but the rest of the Euros are worth a watch

A snoozing fan at England vs Slovenia summed up the mood this week…

US fixed income yields were not much changed over the past week, in the absence of a new catalyst to drive price action. The September FOMC contract continues to price in approximately 70% odds of a first Fed rate cut, though this outcome will be determined by the upcoming data over the next couple of months. Prior to this, barring a more material data surprise, it strikes us that pricing is largely fair and therefore we see the front end of the yield curve trading in a range for the next couple of weeks.

Meanwhile, pricing for longer dated bonds continues to look too rich, given the extent of curve inversion. Typically speaking, yield curves are not meant to be inverted for long periods and negative carry from owning duration is becoming a more important topic, in light of the losses experienced by banks like Norinchukin and others. It strikes us that demand for longer dated assets is set to decline, just at the time when issuance is increasing in the wake of expansive fiscal plans, which can drive curve steepening.

Furthermore, we see US inflation settling around 3.0% to 3.5% over the medium term, and therefore we can't see short-term interest rates falling too far, unless there is a much more pronounced economic slowdown.

In this context, 10-year yields on both sides of the Atlantic, which are trading more than 100bps below current cash rates, appear to discount too much good news and we see scope for disappointment.

Meetings with policymakers in Canada this week serve to remind us how US growth has been much stronger than that seen elsewhere. Given that immigration is currently boosting the Canadian population by around 3% per year, the economy is shrinking on a per capita basis. Meanwhile pressure on infrastructure and housing is increasing social tensions as well as driving up rents, thus holding inflation above the central bank target.

With the Bank of Canada cutting rates to 4.75% earlier this month, we expect some further reductions to follow in the quarters ahead, as the pass-through of higher mortgage rates continues to weigh on aggregate demand.

However, heading into 2025, there is more of a question in terms of how much officials in Ottawa will want to ease, unless those in Washington are also moving the same way. This may mean that 10-year Canadian yields look expensive relative to Treasuries, as well as on an outright basis.

In Europe, all eyes will be on the first round of the French elections this weekend. There has been little evidence of the scare tactics from Macron and team carrying much currency with voters. This week, cries were heard that 'politics of the extremes' could take the country in the direction of civil war, but that seems too hysterical.

We would reflect on the hard right government in Italy as a template for how France could move ahead in the coming months and, in this way, a victory for National Rally may not be the disaster that some in the centre are claiming it may be.

That said, victory for National Rally can certainly add to volatility, with Le Pen keen to cut contributions into the EU budget and eager to pursue a fiscally expansive, populist agenda. This would see French assets retain their risk premium, with this spread being greater in a scenario where the National Rally achieves a clear majority in parliament, as opposed to being the largest party in a fractured and dysfunctional assembly, which would struggle to get anything done.

Meanwhile, as the dust settles, it appears that one of the most important takeaways will be that all roads point to fiscal easing in France and also more generally across the EU. This can support growth but may limit ECB rate cuts in the months to come. In this context, owning bunds as a safe haven on French volatility may not work beyond the very short term.

In Japan, attention has been focused back on the FX market, with the yen breaking through Y160 versus the US dollar in the past week. Markets are wary of imminent intervention. Yet, as we have argued previously, such moves will only tend to have a temporal benefit. The reason the yen is so weak is a function of BoJ policy, and consequently we see renewed pressure on Ueda and colleagues in the run-up to the July BoJ meeting.

We already know that the BoJ will announce a substantial reduction in JGB purchases at this meeting, taking Japan from the era of QE and into QT. However, it also seems possible that the BoJ may raise cash rates to 0.25% at the same time, in a more hawkish move, as it reacts to developments in FX and assesses the inflationary implications.

We continue to hold strong conviction with respect to Japanese policy normalisation and so look for JGB yields to rise. With respect to the yen, the undervaluation of the currency is plain for all to see. However, we need to see clear evidence that the BoJ is serious about normalising policy before the interest rate gap can close and it becomes less unattractive to maintain a long yen position in carry terms.

At some point, a turn in the yen could be a material shift in FX markets, though for now it is striking how low volatility remains in much of the rest of the FX space. Indeed, stress in France and the EU has had little impact on euro versus dollar and we retain a neutral assessment.

Volatility is also low in equity markets with the Vix at its lowest since the pandemic, in the past week. A run-up in certain tech stocks has continued to lift some equity indices to new highs. Meanwhile credit spreads have also benefited from low volatility and a move towards summer markets, away from what has been happening in France and other EU sensitive names.

The televised debate between Biden and Trump seems unlikely to shift voters’ opinions in the US, given how entrenched views on both candidates has already been, amongst voters. The race for the White House remains relatively tight, with Trump the front runner. However, voter turnout in the swing states come November remains set to be the deciding factor.

Looking ahead

European markets may remain more volatile than those in the US in the coming week, as the political drama plays out in France. By contrast, the upcoming election in the UK has been long decided. Without there being much of a contest, the upcoming vote on July 4th seems to be generating about as much excitement as the country's football team, with this seeming to send most people to sleep….