ECB: "{EU} "*ECB'S LANE: EURO-AREA ECONOMY IS FACING MEDIUM-SIZED SHOCK" [...]

Tsy futures remain well bid, near session highs (FVU6 +10 at 107-01.25) ahead of the $70B 5Y note auction (91282CQX2) at 1300ET, WI is currently running at 4.190%, .8bp cheaper vs. last month's tail.

• May auction recap: Little market reaction after May's 5Y Note auction saw a modest 0.1bp tail (12th consecutive!), with a high yield of 4.182% vs the 4.181% when-issued yield at auction cutoff.
• The 5Y sale's peripheral statistics were close to recent averages though for the second straight auction there was the highest indirect takeup since May 2025, which as a proxy for foreign demand may indicate solid foreign bidding (April's saw 72.3% indirects takeup) with relatively low direct takeup (lowest since March 2025).
• Bid/cover 2.34x (5-auction average 2.32x) primary dealer takedown 12.8% (12.2% avg), indirects 74.9% (63.4% avg), directs 12.3% (24.5% avg).

• Last week the US Treasury announced today's $70B 5Y note auction could result in an unscheduled reopening of 7Y notes (SERIES M-2031; CUSIP NO. 91282CKW0). 
• While the funge event appeared likely since last week's announcement, this morning's broad based decline in yields has made a reopening moot given the current 5Y WI running at 4.190%
• Details: if today's $70B 5Y note auction "results in a high yield in a range of 4.250% through and including 4.374%, the 5-year notes will be considered an additional issue of the outstanding 4-1/4% 7-year notes of Series M-2031 (CUSIP No. 91282CKW0) originally issued July 1, 2024.

The reaction to ECB Schnabel’s interview with Die Zeit has been relatively contained, certainly in the context of this week’s overall rally in front-end rates. ERZ6 is still up 9 ticks from last Friday’s settlement levels at 97.385. Schnabel’s hawkish stance is a known quantity, so its not surprising to see her explicitly note that further rate hikes are necessary (her fellow hawk Kazimir said the same following the June decision).

• We note that her comments are not necessarily inconsistent with the “measured adjustment” of policy signalled by President Lagarde on Monday. Since the three possible policy responses to the shock were laid out by Lagarde in late-March, we’ve considered a measured adjustment to be anywhere between 1-3x 25bp hikes (with 2x25bp a plausible baseline).
• Schnabel notes that policy is not currently restrictive. Assuming she sees the upper bound of neutral as closer to 2.50% than 2.25% (she has previously described 2.25% as “firmly neutral”), she may consider two more hikes necessary to make policy restrictive (“the extent and timing of further measures depend on how the conflict, the economy, and inflation develop.”)
• However, at this stage it seems unlikely she would receive widespread support for such a move from the Governing Council.
• Referencing the increased risk of second round inflation effects, Schnabel cites the resilient Eurozone (and global) economy, expansionary fiscal policies and the fact that “the current fall in oil prices should even make it easier for companies to pass on their previously increased costs to consumer prices, because demand is now expected to recover more strongly”.
• While she sees “no indication that wage growth is accelerating or that people expect higher inflation in the long term”, “the memory of the hyperinflation [referring to the 2022 shock] is still fresh, so we have to assume that expectations today are more sensitive to a rise in inflation.”