USDi: BEs move every which way but loose ahead of FOMC

Swerve curve 13 Jun 2022
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A jumpy and erratic pre-FOMC trade intraday pushed and pulled BEs and inflation swaps every which way but loose to ultimately end narrowly mixed.

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  • BEs move every which way but loose ahead of FOMC

  • Barclays: Recent performance of potential inflation hedges

  • Inflation-linked structures

     

    Click here for SDR inflation swap trade

     

    BEs move every which way but loose ahead of FOMC

    Looking at the day-to-day changes on the USD inflations curve in the screens, one could easily come to the conclusion that this quirky market took a pre-FOMC nap this session.  However, these meager closes masked a fairly jumpy and erratic trade intraday that pushed and pulled TIPS breakevens and inflation swaps every which way but loose.  

     

    To be sure, against the backdrop of steadily deteriorating risk sentiment (Dow -0.71%, S&P -1.16, Nasdaq -1.87%), a steady unraveling of an early nominal bid (yields ending ~ 1-4bps higher) and an early rise in energy prices slapped back down (gasoline -1.29%, Brent -0.86%,  WTI -1.61%), the inflation curves oscillated between gains and then to losses to ultimately end mostly narrowly mixed (+/- 1bps).

     

    “Mid-morning proved the main turning point as gasoline rolled over and that eventually wiped away the early outperformance which seems driven by overseas buying in the 5-10y area,” one dealer explained. 

     

    Flow-wise, inflation swap trades thus far on the SDR today included 1y ZC swaps at 396bps, 395.5bps, 390bps, 383.5bps and 382.5bps, 2y ZC swaps at 341bps, 4y ZC swaps at 298.25bps and 294.25vps, 5y ZC swaps at 289bps, 285.25bps and 285.25bps, 10y ZC swap at 267.75bps 267.5bps and 267bps and 12y ZC swaps at 262.875bps and 15y ZC swaps at 254.875bps (for more trades, see Total Derivatives SDR).

     

    Looking ahead, Friday is month-end and strategists at Barclays note that “TIPS flows remain volatile going into month-end, with four days of sizable outflows (greater than $100mn) in the past two weeks.”  As for the shifting dynamic this time around, Bloomberg projects the duration extensions of the Series B and Series L 1-30y TIPS indices to be 0.23y and 0.29y, respectively.

     

    However, inflationistas will have to tackle tomorrow’s July FOMC decision before month-end activity gets into full swing.  Hence, with the Fed tomorrow afternoon, one trader suggested to “expect a quiet morning”, but with month-end on the horizon he cautioned that “the market promises to remain volatile from here."

     

    Heading into the close, the 2y breakeven is going out at 308.75bps (-1.875bps), 5y at 259.125bps (-0.75bps), 10y at 236bps (-0.125bps) and 30y at 218.75bps (+0.25bps).

     

     

    Barclays: Recent performance of potential inflation hedges

    Recently, strategists at Barclays considered the performance of frequently postulated inflation hedges during the COVID era. To do this, the bank looked at the correlations of monthly returns during two time windows: since the beginning of 2020 and since October 2021 (when inflationary fears began to accelerate in earnest). Barclays included a wide swath of asset classes, incorporating commodities, equities, commodity-sensitive currencies, and REITs, with a variety of sub-indices when possible, and even throw in a cryptocurrency index for good measure.  Barclays presents its findings below:

     

      Since January 2020, the asset classes with the strongest positive correlation to the CPI NSA index are largely commodity-focused, particularly the energy subcomponent, along with 5y TIPS breakevens. Strong negative correlations include the 1-30y TIPS index and spot Brazilian real. Given that a large component - though not all - of the current inflationary shock has been compounded by food and energy price inflation, this finding is rather intuitive, as is the fact that the upside inflationary surprise in realized data has driven the Fed into a hawkish stance, causing real yields (and, thus, TIPS) to sell off. Reputed inflation-hedges such as gold, crypto currencies, and equities (especially micro-cap and large-cap growth) have actually been negatively correlated on average with realized CPI NSA since January 2020. In the shorter window - since October of last year - we find stronger negative correlations, especially for TIPS, breakevens, and real estate, likely reflecting the strong influence the Fed’s aggressive hawkish pivot has had across asset classes as inflation has soared in recent months.

       

      “That said, financial assets are valued on a forward-looking basis, so it is arguably more prudent to see what asset classes are best correlated with market-based measures of inflation expectations (we use the Bloomberg breakeven indices as a proxy). Seen this way, since January 2020, commodities retain a solid correlation - particularly energy and industrial metals - while equities and real estate become significantly higher correlated. Gold and TIPS (especially the 1- 30y index) keep a comparatively modest correlation, and while crypto is certainly more correlated to breakevens than realized inflation, the beta is still below that to all selected equity indices. The finding for TIPS makes sense, as inflation-linked bonds are not a pure inflation hedge, but rather a real rate product. Since October 2021, correlations for agricultural commodities and industrial/precious metals have risen, while equities’ relationship has softened. For the latter, this is a reminder that equities have a complicated relationship with inflation: too soft is a sign of weak aggregate demand, a modest inflationary environment is a goldilocks environment that supports earnings growth, but too much price pressure leads to rising discount rates due to a hawkish central bank response. Clearly, in our opinion, we entered the third regime earlier this year, as the S&P 500 is down c.20% from an early January peak.

       

      “These findings reinforce our perspective that an individual asset class’s performance in an inflationary shock regime will be dependent on a variety of moving pieces, including 1) the form the shock takes (the past two years have had a negative demand shock, a positive demand shock, and a negative supply shock, all potentially leading to different betas with realized/expected inflation), and 2) the monetary policy response. Investors who desire a true inflation hedge should focus on asset classes that are closest to pure inflation expressions (such as breakevens or inflation swaps), rather than rely on uncertain and potentially volatile correlations.” 

     

     

    Inflation-linked structures

    • Ascent Finance is working on seven inflation-linked notes via CS maturing from Jan 2027 to Jun 2030 that pays a coupon linked to CPI inflation. EMTN.