Update : 01/21/2025 - 02:30 am GMT
NOTE :
For this new school year, we present to you, albeit late, our best wishes for the new year. As with every break, a few adjustments have been made, regulars will notice them. On the rates page, we have been announcing for some time our intention to modify the American interbank rate, and well, it is more or less done! Why "more or less"? We tried to simplify a Chinese puzzle by splitting it into two parts. The border between certain elements is quite porous, so we do not claim that it is perfect or revolutionary. In addition, what you see is only the visible part of the iceberg, the submerged part being what I like to call "phantom money" (eurodollars, euroyen, euro-euro... I have my doubts about the last one). In any case, it is a subject that we will approach modestly, but Everest is before us.
Another small change, as you will notice, the tone is a little different. For this first time, please be indulgent towards our new voice and its first analyses. What gave us this idea, if any of you would like to write on a subject, do not hesitate, as long as it is professional and financial.
Finally, concerning our end-of-year forecasts, we were completely wrong, we didn’t foresee a "blackout" of the "ATMs" for dollars ! This raises a question: has regulation killed the end-of-year rally? Top chrono: you have less than 345 days left to think about it!
Memento
US Bond Market
This week, the US yield curve remained largely stable, with a marked decline in Treasury bills. For the 4-week maturity, a sharp drop in yields was observed, while a slight tension appeared on the 3-month bills. No significant tension was observed in the interbank market, and this demand for secured collateral raises questions, although the end-of-year period is somewhat special. For the other maturities, the notable decline in volatility and yields seems to indicate that the market is adopting a wait-and-see stance, which should extend until D. Trump's appointment. Before this deadline, the resilience of the US economy, which shows signs of plateauing, should lead to a downward movement in yields, unless inflation or its expectations disrupt this trend.
As of today, SOFR futures and bills do not price in any rate cuts at the late January meeting. This aligns with an overall expectation of a cumulative 25 basis point rate reduction by the end of June 2025
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The US yield curve continues its bear steepening trend (buying short-term rates, selling long-term rates), in a global context where duration is being rejected with great force. The steepening of the curve beyond the 2-year mark, in our view, reflects several key factors.
The first factor is, of course, inflationary fears, even though inflation reflected in yields has evolved more slowly than that of U.S. Treasury bonds. Other factors, such as the promise of massive immigrant expulsions, tariff barriers, rising energy prices, and disappointing agricultural yields, are likely to increase production costs, which could fuel existing uncertainty and amplify market doubts about the possibility of a significant rate cut.
The second factor comes from supply. China is in the midst of a subprime crisis, impacting metal prices. The "debtflation" in China, symbolized by record-low interest rates, could, on the one hand, reduce production capacity, thereby limiting exports to the West, which would be inflationary for the West. On the other hand, the decline in Chinese demand could lead to a recession in emerging market economies, depreciating their currencies, raising the cost of the dollar (already affected by restrictive rates), and complicating their ability to secure monetary supplies.
The third factor is related to Japan, which is pursuing a monetary tightening policy (QT) and rate hikes. The Japanese appear to be selling assets and reducing liquidity in the markets, and the unwinding of "carry trades" is contributing to the depreciation of emerging market currencies, increasing pressure on long-term rates and their volatility. The fourth factor is more technical and tied to the money market mechanics. While bank reserves are still abundant, they are closer to a zone of turbulence. Furthermore, the balance sheets of key intermediaries are increasingly constrained, which raises refinancing costs in the markets, in the context of particularly high demand. The Treasury plans to reduce "bill" issuances and increase coupon bond issuances, in a world that demands fewer could put additional pressure on rates and further drain liquidity.
Finally, the last factor is the uncertainty surrounding Trump’s geopolitical policies. It is likely that Trump will use the dollar as a "bargaining chip" with both allied and antagonistic countries to reduce the trade deficit and secure US exports and strategic supplies. In other words, we believe that rate valuations will increasingly depend on politics, especially on countries' ability to negotiate with Trump. Allies will likely see their currencies appreciate against the dollar, while others will face the adjustments of Trump’s policies. In this context, we encourage everyone to reflect on the words inscribed on the $1 bill: "In God We Trust."
European bond market
Europe is facing a similar situation, with a "rise in long-term rates / drop in short-term rates / QT" tightening financial conditions. Excessive liquidity drainage has led to a drop in financing needs. Added to this are disastrous political choices and sluggish growth, which could result in at least four rate cuts in 2025, according to the Euribor curve, while other countries anticipate only one or two.
Yield curves are also steepening sharply, with a speed premium for Italian and French bonds. Swap spreads indicate high balance sheet costs for intermediaries on German debt, even for maturities of 2 to 10 years. In contrast, for peripheral countries’ debts, a "discount" is visible. This explains the stable yet significant spreads for the Bund.
At the same time, the rise in long-term yields, further driven by Asian investors using Europe as a proxy by selling assets to finance dollar purchases, adds additional pressure. However, the demand for safe assets in the eurozone remains very strong, creating a "scarcity premium" even on peripheral securities.
Regarding the underlying trend of the spreads, no changes are observed. The main European 10-year spreads against the German 10-year remain oriented downward, with a target of 105 bp for Italy and 62 bp for Spain. The spread against the French 10-year is easing, but without reversing its underlying upward trend, a trend that remains similar against of other main European 10-year spreads.
This week, European bond markets showed less volatility than the US market. Volatility was particularly high in the Italian market, driven by the 2 and 5-year maturities. In contrast, the German market recorded a decrease in volatility across the entire curve starting from the 5-year, with a particularly marked drop for the 30-year. The French market, for its part, saw a slight increase in volatility, especially for the 5-year, while the 30-year followed the trend of the German 30-year.
Long-term volatility (HV) remains generally bearish, but the rebound in short-term volatility, mainly due to short maturities, will eventually significantly slow down this bearish trend, or even stabilizing it temporarily. The volatility gap between European bond markets does not reverse. Thus, volatility in the French market continues to rise compared to the Italian and German markets. Finally, the sharp volatility movement in the Italian market this week interrupted, but did not reverse, the bearish trend compared to the German market.
As of today, Euribor and ESTR futures anticipate a rate cut of about 25 basis points by the end of January 2025, which is part of an overall expectation of a cumulative 100 basis point cut by the end of December 2025.
You will find details of the various components of European bonds below and more in the Interest Rates section.
EURUSD parity
In a general context of a strengthening dollar and a weak euro, the EURUSD parity remains generally bearish, evolving in the lower part of its range. Its trend remains bearish, despite a slight correction observed last week. Its historical and implied volatility has decreased, although it remains high for the historical.
At the fundamental level, the yield differential between US and European rates, as anticipated by the markets, suggests a possible approach to parity between the euro and the dollar. This differential is aggravated by the failure of the German economic model, with its domino effects, creating an environment conducive to a structurally weak euro. This situation is particularly problematic for the eurozone, especially in a context where growing protectionism, potentially driven by the United States, could limit export capacities, while energy costs continue to weigh heavily on the economy.
In addition, political instability within the European Union further exacerbates these tensions, further complicating the economic outlook and the rise of the single currency.
However, in this generally bearish context, a temporary resolution of the Ukrainian conflict, desired by Trump and probably also by Putin, could potentially reverse the trend. This confirms the hypothesis that the valuation of assets traded globally could be influenced by Trump's political decisions. To be continued...
Equity Indices
In the United States, equity indices posted a weekly rebound following a correction observed last month, primarily attributed to a decline in liquidity. While we anticipate medium-term bullish potential, certain downside risks remain. In an optimistic scenario, China and the U.S. Treasury could support economic activity through stimulus policies and liquidity injections, thereby benefiting equities. Additionally, the FED could intervene in response to short-term rate volatility by injecting more liquidity to strengthen the balance sheets of financial intermediaries. These factors, combined with high corporate profits and expansionary policies supporting demand, could create a unique dynamic: a positive demand shock coupled with a negative supply shock, boosting asset valuations through a new phase of monetary expansion.
However, several bearish factors continue to weigh on the outlook. Elevated uncertainty persists, a strong dollar hampers foreign purchases, and intermediation constraints limit financial leverage. Furthermore, the potential rise in credit spreads, currently at historically low levels, could further pressure the markets.
In China, despite the possibility of stimulus measures, the economic outlook remains mixed, particularly due to structural challenges within its economy and a real estate market still struggling. Nevertheless, these hurdles could be partially offset by policies supporting economic activity, indirectly providing a boost to global markets.
In this context, we expect equities to continue their upward trajectory, although liquidity is likely to concentrate primarily on large companies benefiting from tax cuts and protectionist measures introduced under the Trump administration.
This week, historical volatility (HV) of equity indices recorded a pronounced increase in US markets, mainly driven by the Dow Jones index, while the increase in volatility of other US indices remained modest. In Europe, a significant increase in volatility was also observed, mainly driven by the DAX, followed to a lesser extent by the CAC 40 and the FTSE.
In Asia, volatility (HV) of indices increased modestly, with the Nikkei and the Hang Seng increasing slightly, while that of the Nifty declined.
Overall, the long-term historical volatility (HV) of US, European and Asian indices remains oriented upwards. However, in the short term, a pause in this trend appears to be emerging.
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