Ceasefire, rates and the US consumer

ECB Rate Hike Outlook and European Rates

• Market pricing for fewer than two ECB rate hikes this year (June and July) is viewed as unlikely despite the ceasefire announcement, driven by three factors:
  • Residual uncertainty regarding negotiations over the next two weeks.
  • Persistent energy supply shocks; even with the Strait of Hormuz reopening, commodity analysts project oil averaging $100/barrel and Dutch TTF gas rising toward €90/MWh due to permanent infrastructure damage.
  • ECB inflation baselines remain higher than current market prices, with March forecasts still projecting inflation above 2% in 2027 after accounting for one to two implied hikes.
  • Client concerns regarding recession risks from energy shocks are countered by the argument that reduced geopolitical uncertainty may allow the ECB to navigate these risks without policy errors.
• Limiting factors for curve steepening in German two-year to 10-year yields include:
  • Macro: Growth downside risks and fading extreme fiscal fears if the conflict ends definitively, reducing supply concerns for the back end of the curve.
  • Relative Value (RV): The German curve has already out-steepened global peers by approximately 15 basis points.
  • Positioning: Market positioning remains long two-year contracts and short 10-year contracts, indicating the steepener trade is already priced in.
• 10-year bond yield forecasts:
  • Yields are expected to decline toward 2.9% as markets price in two ECB hikes.
  • Yields may rally further to 2.7% by 2027 as the ECB cuts rates next year.
  • Yields are expected to become less sensitive to front-end rates and hawkish ECB communication.

Volatility Market Dynamics

• General Reaction: Geopolitical volatility declined post-ceasefire, reflecting a pricing reduction in worst-case tail scenarios, though levels remain elevated compared to pre-war baselines.
• Regional Divergence:
  • European volatility led the global spike due to higher sensitivity to oil shocks and ECB policy shifts, but is now lagging the US.
  • Relative Euro vol is currently considered "rich" versus US dollar vol, presenting an opportunity to position for Euro vol underperformance.
• Asian Exception: Japan and China markets showed immunity to geopolitical shocks;
  • China is the only market where volatility is lower than pre-war levels.
  • Chinese volatility term structure steepened due to record levels of callable supply in Q1, contrasting with the inversion seen globally.
• Forward-Looking Assessment: A return to the pre-war "long carry" environment is possible but contingent on durable peace negotiations;
  • Volatility is expected to remain structurally higher than early 2024 levels due to the potential for conflict flare-ups and the "bifurcation" risk surrounding upcoming US midterm elections.

US Consumer Data and Spending Behavior

• Overall Performance: US consumer spending remains robust, with March growth at 3.2% (excluding a 16% spike in gasoline spending), outperforming the second half of the previous year.
• Drivers of Strength:
  • Tax refunds increased year-over-year by approximately 12%, providing liquidity for discretionary spending and necessities.
  • Higher income consumers benefited from equity market tailwinds and strong wage growth.
• K-Shaped Recovery Dynamics:
  • Spending growth diverged significantly by income tier in March: higher income grew ~4%, while lower income grew ~2%.
  • Discretionary spending growth (leisure, travel) ticked up for middle and higher income groups but declined for lower income consumers.
  • The overall spending gap may narrow slightly due to gasoline shocks, which disproportionately impact lower-income budgets, but the underlying divergence in discretionary spending persists.
  • Lower-income weakness is currently considered less critical to the overall macro picture as this demographic accounts for a smaller share of total spending.
• Impact of Gasoline Shocks:
  • Unlike previous shocks (post-GFC, 2016-18), data has not yet shown pullbacks in durable goods, electronics, or autos.
  • No significant reduction in grocery basket quality observed yet; consumers appear to be absorbing costs via tax refunds and reserves.
  • Potential behavioral shifts (trading down groceries or pulling back on durables) are expected to materialize only after the current stimulus effects peter out, likely several months away.
• Real vs. Nominal Growth:
  • Total car spending growth was 4.3% YoY in March, with roughly 1 percentage point attributable to price effects (gas).
  • Core CPI shows no uptick in inflationary pressure compared to Q4 2023.
  • Data indicates the spending strength is largely driven by volume (transaction swipes) rather than price inflation, though future price effects remain a risk if gas prices stay high.