08:13 AM EDT, 05/30/2024 (MT Newswires) -- Calm returned to the long end of the bond market after the rout of the last 48 hours lifted United States Treasury (UST) 10-year yields over 4.60% and Bunds to 2.69%, said Societe Generale.

The bear steepening revival followed the indigestion of UST supply in two-, five- and seven-year points of the curve caused flight-to-quality in foreign exchange (FX) and lifted the US dollar (USD) versus G10 and emerging markets (EM), wrote the bank in a note to clients. The DXY consolidates in Asia just above the 50dma situated at 105.10.

EUR/USD stays offered below 1.08 placing it in danger of retesting the 200dma at 1.0785. Profit taking in EUR/CHF was initially sparked by risk aversion but extended below 0.9850 after comments by Swiss central bank (SNB) President Thomas Jordan. Speaking at a conference in South Korea overnight Wednesday, Jordan said a weaker Swiss franc (CHF) "is currently the most likely source of higher Swiss inflation."

SocGen doesn't think this necessarily derails a second rate cut at the next meeting either in June or in September based on the very subdued inflation forecast from March based on a constant policy rate of 1.50%. Besides the deluge of benchmark supply in the US but also in Europe, the culprit of the breakdown of Bunds can be partly traced back to the jump in real rates.

Is the market telling the European Central Bank (ECB) it cannot cut rates after June, asked SocGen. Spain's consumer price index (CPI) followed in the same vein as Germany, surprising to the upside in May. HICP in Spain inflation accelerated to 3.8% y/y in May from 3.4% in April. Core rose to 3.0% y/y. This skews the risk to the upside for eurozone CPI on Friday. According to the bank's economists, the rise to 2.8% y/y in Germany was almost entirely driven by services, which rose by 0.5pp to 3.9% y/y.

In the US, the "indigestion" of supply was complete last night when the seven-year UST auction tailed 1.3bps. This points to increased anxiety over deficits. Primary dealers were reportedly holding record longs in the three- to six-year bucket prior to this week's supply so perhaps SocGen shouldn't overplay the public finances card. The Beige Book late Wednesday noted a "modest pace" of price increases as consumers push back against additional price increases. Federal Reserve members John Williams and Lorie Logan are on the agenda on Wednesday. Raphael Bostic still believes a rate cut is possible in Q4 2024.

For the large majority of ECB council members, the re-acceleration of inflation in May and wages in Q1 is no reason to defer a first rate cut or talk down the probability of additional easing in H2, pointed out the bank. The difference in policy communication on both sides of the Atlantic is striking. Where the Fed is navigating a more hawkish trajectory, the ECB is more inclined to bring down the level of policy restriction even with inflation picking up, although from a lower base compared with the US.

Stronger Q1 wage growth has been played down. Perhaps it is this insouciance that explains the underperformance of Bunds this month relative to the US and United Kingdom Gilts, added SocGen. European 10-year real rates are up 17bps compared with -1bp for the US and +9bp for the UK. The market is effectively tightening financial conditions, telling the ECB the room for maneuver is limited. For the 10-year IRS, Wednesday's close at 2.93%, above the 200dma, puts a return to 3% in play. In spreads, the end of May is characterized by an abrupt return to bear steepening after three weeks of relentless bear flattening.

In FX, the breakdown in EUR/GBP below 0.85 triggered a number of SocGen client enquiries about the tactical outlook. The move dovetails with the widening in 2y2y UK/EU rate spreads but the bank has no visibility on how much of the move can be attributed to month-end flows. Even after the bounce following German CPI and the spike in Bund yields to 2.69%, EUR/GBP sellers stepped in.

Tactically, the case can be made for a deeper retracement towards 0.8400 though technical hurdles stand in the way at 0.8480, 0.8465, 0.8440. Fundamentally, the case for lower EUR/GBP can be made based on the Bank of England/ECB divergence and the UK election in July.

Starting with the politics, a Labour government is likely to pursue closer realignment with the EU (trading relationship), according to the bank. This doesn't imply the United Kingdom rejoining the single market or the customs union but improving the existing Brexit deal. On the policy rate, with a UK rate cut off the table after CPI last week, this means the ECB will cut rates at least once before the BoE, possibly twice if the ECB cuts again in September and the BoE holds fire also in August. This would see the rate spread widen by potentially 50bps to 200bps in favor of sterling (GBP) over the next four months.

Upside risk for the cross mainly stems from a much closer election outcome (smaller Labour majority, hung parliament), and summer turmoil in risk assets.

In EM, SocGen pencils in no change for rates Thursday in South Africa. The central bank (SARB) is forecast to stand pat at 8.25%. The decision Thursday is a sideshow to the election outcome, the rand (ZAR) slipped over 1% to 18.65/USD and the 10-year SAGB yield climbed 8bp early Thursday to 12.13% as early results based on around 10% of polling stations, the ruling ANC is projected to win about 42.3% of the votes (short of the 50% tally needed to form the government).

It could take up to one week for the final results to be announced. Early projections indicate that the ANC may have to resort to an alliance with smaller parties to form the next government.

Elsewhere, Indian bonds received another shot in the arm Wednesday after S&P upgraded the rating outlook to positive from stable based on the strong growth fundamentals. It retained the BBB- rating. A new government will be in place by this time next week but it appears investors have discounted all the positives including a Modi 3.0 government, the inclusion of INGBSs in the JPM EMGBI index as well as the record special dividend payment from the Reserve Bank of India (RBI) to the government. The 10-year INRGB yield consolidates at 7.0% and the rebound in USD/INR is technical rather than fundamental, related to month-end US dollar demand by oil importing companies.