USDi: TIIJul32s lovefest before a dose of reality sinks in for BEs

Rollercoaster top 26 Aug 2020
BEs cruised into today’s $15bn 10y TIPS tap with a bid and shot even higher the strong results. But then BEs got hit amid today’s bearish sentiment.

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  • TIIJul32s lovefest before a dose of reality sinks in for BEs

  • BofA: Difficult to put the inflation genie back


    Click here for SDR inflation swap trade


    TIIJul32s lovefest before a dose of reality sinks in for BEs

    Despite the Fed’s ongoing and steadfast battle against inflation – that got another big exclamation mark at yesterday’s FOMC hike/decision – demand for inflation protection is apparently still alive and well judging from today’s 10y TIPS re-opening.


    To be sure, today’s $15bn tap of the TIIJul32s stopped a solid 4bps through the 1pm WI level to draw a stop-out yield of 1.248% - the highest 10y TIPS auction stop since July 2010 – and a rather solid 2.4x bid-to-cover ratio.  Indirect bidder grabbed 70.8% of the issue while directs took down 21.3%, leaving dealers with a 7.9% odd lot – their smallest allocation on record.


    However, despite these solid auction statistics, today’s TIPS supply came amidst a broader hangover in the financial landscape from yesterday’s hawkish rate hike that saw both equities and nominals trading lower today – the latter hit particularly hard (~ up to 17bps) in a move likely exacerbated by BoJ currency intervention (and subsequent selling of USTs).


    Thus, while breakevens cruised into today’s auction better bid across the board and then popped higher still once the results hit the tape, the inflation market was not completely immune to the broader bearish backdrop today as breakevens quickly came off the post auction highs to end the session mixed (+/- 3bps) as the curve steepened. 


    Still, the 10y sector outperformed on the day owing largely to the solid auction demand on a journey that saw it pop up to an intraday high of 244bps before settling back down at 239.875bps, or just 3bps higher on the day.  "While buyers were focused on the auction, real yield sellers were present all day and it was too much for the market leading to a massive correction," one dealer explained.


    Flow-wise, inflation swap trades on the SDR today included 1y ZC swaps at 277bps and 276bps, 2y ZC swaps at 295bps, 5y ZC swaps at 280.875bps, 280.5bps and 276.375bps, and 10y ZC swap at 263.125bps…(for more trades, see Total Derivatives SDR).


    Heading into the close, the 2y breakeven is going out at 233.625bps (-2.75bps), 5y at 249.75bps (-2.25bps), 10y at 239.875bps (+3bps) and 30y at 230bps (+2bps).



    BofA: Difficult to put the inflation genie back

    Strategists at BofA recently took a look at cases of inflation above 5% in advanced economies (AEs) in 1980-2000 and they find that “it took on average 10 years to bring it back to 2%.”  Thus, while the consensus still expects G10 inflation to drop to 2% by 2024, the bank is “concerned it could take longer.”  BofA looks at two scenarios where: In a positive scenario, inflation starts to move in the right direction at a sufficient pace for central banks (CBs) to avoid a hard landing, even if inflation remains above 2% in the medium term. In a negative scenario, inflation is persistent and sticky on the way down, forcing central banks to a hard landing.  


    BofA expounds on the scenarios and which one of them it believes will unfold this time around below:


      ”… In the positive scenario, inflation starts falling in the months ahead and in the next 2-3 years converges towards a level still above the 2% target, but not too far, let's say 3%. Central banks still keep the 2% target, but accept that it will take longer to achieve it. They keep rates high for longer, without hiking further once inflation starts on this downward path in the next few months, but they also don't cut rates before inflation comes closer to the target. Risk sentiment may suffer in the short term, adjusting to rates being high for longer, but should recover next year. Accepting high but moving-in-the-right-direction inflation can also help with debt dynamics. Real GDP growth will slow to well below potential and we may even have a mild recession, but nominal GDP growth will remain historically high. This is a soft-landing scenario and remains our baseline.


      “…In the negative scenario, inflation is more persistent. It takes longer for inflation to peak and it eventually converges to a level well above the target, let's say 5%, in the next 2-3 years. In this case, central banks will have to hike more than current market pricing and keep rates high for longer. Unless they give up on their inflation target, they will not be able to avoid a hard landing. Risk assets will suffer more and for longer. This is not our baseline, but risks for such a scenario are increasing, in our view.”