USD Swaps: CB hikes still a hard pill to swallow; Duration sentiment shift?

CB hikes still a hard pill to swallow; Duration sentiment shift?

This week’s round of central bank rate hikes still remains a hard pill to swallow for the financial landscape today as just about all the major global equity indices are ending out the week in the red, including our favored domestic trifecta of bourses which are also in the red in the early afternoon trade (Dow -1.57%, S&P -1.68%, Nasdaq -1.44%).  And this morning’s softer-than-expected S&P Manufacturing PMI (46.2 versus 47.8 Bloomberg consensus) is adding more fodder to the narrative that the Fed will hike the economy into recession.

And with this very sentiment sinking into the collective market psyche, Treasuries are currently well-off their earlier lows in a front-end-led move.  The benchmark 10y note yield is last 1.6bps higher at 3.462% after a brief test of 3.56% earlier while the 2s10s spread is 8.9bps wider -70.5bps as the front-end has steadily nudged into the black today. 

Meanwhile, swap spreads are mostly wider with the spread curve flattening against the steepening in underlying rates.  In the backdrop, IG issuance remains offline and will likely remain so for the remainder of the year, sources suspect.  And notably, syndicate desks are reporting a 16% drop in IG issuance compared to 2021 amid headwinds of lower equity prices and higher yields.

More broadly, rates market sentiment has shifted meaningfully with the past two CPI reports as each report reflected a downside miss versus consensus and bolstered market belief the long-awaited inflation fall is here. And if inflation is falling, strategists at BofA reckon that “investors believe bonds are back” and they favor buying dips in 2023:

”…Investors are likely still underweight duration as bonds regain their value in portfolios. Underweight positioning is reflected in CFTC speculative positioning and consistent with client conversations. Clients say they were very underweight in '22 & are not as close to neutral as they would like today. Investors will thus be buying on dips.

 

“…The UST long end should be well supported with falling inflation, slowing economy, & risk asset challenges. The main risks to owning the long end: (1) stronger economy (2) higher inflation risk premium (3) UST liquidity. Strong economy could see more Fed tightening & harder landing risks, limiting back-end rise. Inflation can be hedged by owning TIPS. Liquidity should improve with lower vol.

 

“…It is highly unusual for a recession - or significant slowdown - to be so well telegraphed by the Fed and expected by markets. This greatly supports a buy dips approach in bonds because the cycle's end-game is thought to be known in advance with confidence. With increasing conviction that central banks will deliver a slowdown, we expect bond investors to increasingly adopt a buy-dips investment strategy for the UST long end.

 

“…The front end is safe over a 1-2Y horizon (2y rates held for 1y need to see 1y rates next year above 9% to lose money), but can be volatile as the Fed seeks out a sufficiently restrictive policy rate (5%+ is still possible). Even if terminal is well above expectations, this should add to conviction around the cycle turn and demand for the long end.

 

“…We think 10yT are biased to remain in a 3.25-3.75% range until there is a material shift in underlying US macro data, as we discussed last week. The recent shift in sentiment suggests any rate 10y rate backup will be bought below 3.75%. We still think 10Y = 3.25% at end '23.

 

“…The globally synchronized tightening over the last year exacerbated the bearish impact of any individual central bank communication, and so too will synchronized moderation. The former drove a bias towards shorting USTs on upticks throughout most of '22, even as yield levels overshoot fundamental valuations materially. The latter is likely to drive a further shift in the market dynamic towards a buying the dip bias.

 

“…Bottom line:  Dec FOMC was hawkish which poses upside risk to mid '23 rates & further flatting pressure on the curve. Duration sentiment shift & positioning will likely keep back-end USTs well supported. Long end UST investors likely to be buying dips in '23.”

Currently, SOFR swaps – 2s 3.5bps (+1.125bps), 3s -13bps (+1bps), 5s -21.875bps (+0.25bps), 7s -32bps (-0.125bps), 10s -29.25bps (+0.25bps), 20s -60.875bps (-0.125bps), 30s -66.625bps (-0.125bps).