Window dressing

U.S. Federal Reserve and Rate Strategy

• Fundamental Outlook: Strategists maintain a "bear flat" view for the U.S. yield curve despite recent "bear steepening" post-FOMC, citing robust underlying growth and elevated, sticky inflation as dominant factors.
• Policy Constraint: The firm believes current U.S. rates are not sufficiently restrictive to return inflation to 2.0%, implying the Fed must eventually tighten further to flatten the curve.
• Communication Volatility: Market curve behavior remains highly susceptible to inconsistent messaging from Chair Powell rather than pure fundamentals.
• Midterm Elections (Forward-Looking):
  • Base Case: Market pricing suggests a Democratic sweep (67% probability), which is largely priced in.
  • Democratic Outperform ("Blue Wave"): Defined as Democrats gaining 53+ Senate seats; expected to drive bear steepening due to anticipated higher taxes/regulation.
    • Price Impact: 2-year down 5–7 bps; 10-year down 3–5 bps.
  • Republican Outperform: Expected to drive bear flattening due to expectations of lower taxes and regulation.
    • Price Impact: 2-year up 7–10 bps; 10-year up 3–5 bps.
• Treasury Refunding (Forward-Looking):
  • Supply Cuts: Strategists assign a 40–50% probability to Treasury announcing auction size reductions in the 20- and 30-year sectors at the November refunding.
  • Timeline: Potential cuts of $2–3 billion could be announced immediately, with a clearer signal likely in February; forward guidance maintenance for "at least the next several quarters" may be removed to pave the way.
  • Catalyst: Reduced long-end support would be triggered if bond price action resumes negative momentum post-Powell's press conference.

European Central Bank (ECB) Strategy

• Communication Tone: Recent ECB communications were "dovish but deliberately not too dovish," serving as damage control following the September meeting.
  • Statement: Highlighted good underlying inflation/wage behavior while acknowledging growth downside risks (energy shocks, tight financial conditions).
  • Press Conference: Chair Lagarde signaled a rate hike remains the clear direction of travel, with December being the likely timing.
  • Market Signals: Post-press conference leaks and Reuters reports confirmed December hikes and suggested a potential pause afterward.
• Curve Positioning:
  • Strategy: Favor bullish positions in the "belly" of the euro curve (intermediate maturities).
  • Rationale: Growth concerns and bond sell-offs are currently impacting intermediate yields more than the front end; long positions on the front end are deferred until a clear shift away from hiking occurs.

United Kingdom Rates Strategy

• Budget Impact: The UK budget was viewed as "tame" with muted market reaction, featuring "bull flattening" on the long end.
• Gilts Supply Dynamics:
  • Long-Dated Supply: The DMO plans to raise only 6% of remits via the long-dated gilts bucket this fiscal year, down significantly from 21% last year.
  • Ongoing Volume: Despite the reduction, the DMO must still sell >£10bn of longs over the next five months (following £5bn in the prior seven months).
  • Net Financing: A £7.5bn increase in net financing requirement was smaller than the market's £10bn expectation; future gross financing projections for 2030-31 were raised only slightly above consensus.
  • Cross-Financing: Expected to rise from £275bn this year to £312bn next year.
• TBOS Initiatives:
  • New Instruments: Introduction of 12-month TBOS (auctioned monthly) and the TBOS standing repo facility (TBSRF) launching in January.
  • Strategic View: The TBSRF is deemed the most critical announcement, offering more generous terms than gilts to act as "training wheels" for the market until the TBOS market deepens.
  • Bias: Remain comfortable with "bull steepeners" given the supply challenge and market repricing of bank rate paths.
• Bank of England (Upcoming Decision):
  • Hike Probability: A 25bps hike is effectively priced in.
  • Voting Split: Expected to be 7-2 in favor of a hike, with Taylor and Dhingra voting to hold.
  • Forward Guidance: A dovish message limiting further tightening is anticipated; such a signal could trigger a market reaction similar to May 2023, pushing forward meeting rates lower.
  • Trade: Longing the 1-year forward SONIA and shorting June 2027 SONIA against Bank of England rates.

French Sovereign Risk & OATs

• Market Sensitivity: OAT spreads remain highly correlated to global risk assets (specifically U.S. equities) and remain "at the mercy" of risk sentiment.
• Fiscal Outlook:
  • Rating Reaction: Recent ratings news was encouraging, suggesting appetite for cheap valuations in OATs versus swaps.
  • Budget Passage: An increased likelihood of the budget passing in its current format would result in a 5% deficit next year and substantial fiscal tightening, supporting OATs.
• ECB Backstop:
  • Thresholds: The ECB has not signaled a willingness to alter Quantitative Tightening (QT) or alter its Outright Monetary Transactions (OMT) thresholds.
  • Risk: The threshold for ECB intervention remains "pretty high" relative to market expectations, leaving France vulnerable to spread widening if fiscal news deteriorates.