BofA Global Rates Weekly: Flight to safety lifts bonds, but French spreads and rate-hike risks remain

Why does BofA still expect a US rate hike as bonds rally?

Falling equities, widening credit spreads and pressure on French government bonds reinforced one another. Safe-haven flows and short covering by trend-following funds pushed US Treasuries higher, bringing the 10-year yield below 5%. BofA sees the move as a correction after yields rose.
BofA still expects the Federal Reserve to raise rates in October, citing resilient US growth and persistently high inflation, while the market has priced in almost none of the hike. The bank maintains its short position in 2-year US Treasuries, but a further decline in yields would trigger more short covering and hurt the position in the short term.
Its medium-term view is that rate hikes will eventually contain inflation, narrowing the spread between 2-year and 30-year yields. But if the Fed holds rates and its press conference fails to persuade markets, BofA estimates that long-end yields could rise more, widening the spread by 5–7 basis points instead.

For the 4 November refunding announcement, BofA's low-conviction base case remains unchanged issuance of coupon-bearing Treasuries, but it assigns a 40%–50% probability to a cut in long-end issuance. The dealer survey has begun asking about structural changes in investor demand, opening room to adjust supply.
BofA believes supply of 20–30-year debt exceeds demand. Reduced issuance could improve long bonds' prices relative to swaps, supporting its trade positioned for a wider 30-year swap spread. If long-bond yields rise sharply before the meeting, the likelihood of a more active Treasury issuance adjustment would also increase.

The spread between French and German 10-year government bonds has reached its widest level since the peak of the sovereign debt crisis. Its drivers have expanded from interest costs and technical factors to equities, geopolitical news and weak data. BofA's model puts it about 80 basis points wide relative to its relationship with short-end rates, and about 35 basis points wide relative to other European government bonds.
The valuation divergence has not attracted enough buying support. As of 20 October, the tracked OAT futures accounts remained net long, with outstanding longs 14% higher than on 10 September. The spread must first stabilize to attract new buyers; continued widening would also increase concerns about forced selling.
The ECB faces both rising energy prices and tighter financial conditions. BofA expects it to hold rates next week, adopt a slightly dovish tone while retaining a tightening bias, and possibly offer verbal reassurance on spreads. If markets remain disorderly, pausing PEPP balance-sheet runoff is also a possible communication option; related maturities in 11–December amount to 21 billion euros.

After hawkish remarks by Australia's deputy central bank governor, markets priced in a 15-basis-point hike in November. BofA economists expect third-quarter trimmed mean inflation of 0.9% quarter on quarter and no central bank hike. Its rates team, however, believes that reading would be enough to push the market-implied probability of a hike to 70%–80%, while a higher reading or stronger components would lead to a hike.
BofA therefore favors a narrowing of the Australian 2-year versus 10-year spread: inflation risk supports short-end yields, while expectations of a medium-term reversal of tightening constrain the long end. Japan is the opposite: BofA expects rates to remain at 1.25% next week, and the market has already priced in a probability above 70% of a hike in December. With limited room for further repricing at the short end, it favors a steeper yen 2-year versus 10-year overnight index swap curve.
There are also opposing forces at Japan's long end: life insurers' net purchases of super-long government bonds rose from 300 billion in August to 530 billion yen in September. Together with foreign purchases, this could limit the rise in long-end yields; existing market flows still favor curve flattening.

BofA expects UK forward real rates to fall relative to those in the euro area. Revisions to international investment position data improve the UK's relative position, while a shorter average government bond maturity and lower future supply of inflation-linked bonds are also expected to ease long-duration supply pressure.
The bank recommends receiving the UK and paying the euro-area 20-year real swap rate starting in 10 years, with an entry spread of 130 basis points, a target of 90 basis points and a stop-loss at 150 basis points. A clear departure from fiscal discipline in the UK is the main constraint on this relative-value trade.