USDi: BEs finally start – tepidly - showing first signs of life for 2023

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BEs finally start – tepidly - showing first signs of life for 2023

The U.S. inflation market finally started showing its first – albeit tepid - signs of life in the new year today. 

To be sure, despite better than expected data (i.e. jobless claims, ADP) and the latest round of hawkish Fed-speak (i.e. George, Bostic) that derailed both nominals (~ up to 11bps) and the major equity indices (Dow -1.02%, S&P -1.22%, Nasdaq -1.47%) since the early trade this session, TIPS breakevens and inflation swaps were marked roughly 1-3bps higher in the 2y-30y sector as the energy complex finally found some better footing today (gasoline +0.32%, Brent +1.08%, WTI +1.21%).

However, despite today’s - admittedly tepid – bounce, some remain hesitant to conclude that the inflation market has turned the corner.  Indeed, one trader quipped that “breakevens found their footing today though the overall tone remained suspect.”  Notably, he found that after an early morning bounce due in part to the modest rebound in energy, “there still seems to be sellers of strength and I would hesitate to predict any larger rebound until the commodity complex can sustain positive momentum.”

Flow-wise, in derivatives-space, inflation swap trades on the SDR today included 1y ZC swaps at 219.5bps, 2y ZC swaps at 230bps and 230.5bps, 4y ZC swaps at 233.75bps, 5y ZC swaps at 237.75bps, 238bps and 238.25bps, 7y ZC swaps at 241.25bps, 10y ZC swaps at 242.5bps and 242bps, 15y ZC swaps at 242.5bps, 20y ZC swaps at 239.875bps, and 30y ZC swaps at 242.475bps and 241.25bps (for more trades, see Total Derivatives SDR).

Heading into the final hour of trade, the 2y breakeven is going out at 219.25bps (+4.385bps), 5y at 225.125bps (+2.375bps), 10y at 222.125bps (+2.375bps) and 30y at 227.875bps (+1.5bps).

Citi: TIPS supply-demand dynamics

Looking at the TIPS supply/demand dynamics for 2023, strategists at Citigroup expect a weaker dollar to increase TIPS demand from foreign officials and steepen the 5s30s IOTA curve.  The bank expounds further on this view below:

”… TIPS supply-demand dynamics - TIPS auction sizes have increased steadily throughout 2022 as Treasury tried to capitalize on investor demand for inflation protection. 5y new-issue auctions sizes have increased from $19bn in Q4 2021 to $21bn in Q4 2022. 10y new-issue auction sizes increased from $16bn to $17bn. 30y auction sizes stayed constant at $9bn... We do not think the Treasury would increase TIPS auction sizes further in 2023. Even with the increased auction sizes and the lack of Fed purchases, net supply in 2023 is expected to be around $51bn after adjusting for inflation accrual which is less than the $60bn net supply in 2022. This is because of the larger redemptions in 2023.

 

“…The fourth quarter of 2022 was the first quarter since the pandemic with no fed purchases or redemptions in TIPS. This meant that the market was forced to absorb the full gross supply of $55bn and so far, that has not been going well. We have seen a decrease in demand from investment funds which takedown majority of the TIPS offerings at auctions...The average TIPS auction takedown splits in 2022 for the three tenors (5y, 10y and 30y). In 2022, investment funds purchased 74% of the 5y TIPS offerings and 72% of the 10y TIPS offerings at auctions. In comparison, investment funds accounted for 79% and 75% of the 5y and 10y auction purchases respectively 2021.Over the last few months, we have also seen a string of investor outflows from inflation-related mutual funds.

 

“…Amid this decline in TIPS demand from investor funds, dealers had to step-in and absorb most of the TIPS especially in the second half of this year. Dealer inventories of TIPS increased rapidly over the last few months...and are currently at the highest levels since 2013. The increase in dealer inventories were mainly driven by TIPS with less than 6y to maturity. While this can be partly attributed to lack of investor demand, we think foreign reserve manager sales was the main driver behind this build-up in dealer inventory.

 

“…While foreign investors are not the biggest purchasers of TIPS during auctions, according to the most recent annual TIC report, foreign investors held about 43% of the total TIPS outstanding as of June 2021 compared to 38% of the total nominal bonds outstanding....Foreign officials have historically held the majority of foreign TIPS holdings...The maturity structure of foreign official TIPS holdings. Clearly, a vast majority of their holdings is in the <5y sector. So, any decrease in demand from foreign officials will have a much bigger impact on the very front end than on any other sector of the TIPS curve. Over the past few months, a hawkish fed policy combined with risk-off sentiment has pushed dollar higher against other major currencies. This led to reserve managers selling USTs to protect their currencies. Japan is a prime example for this. As USDJPY moved closer to the 150 level, Japanese officials sold about $39bn USTs in September. This decrease in official demand led to the buildup in frontend dealer inventory."

 

“…Reserve manager demand might return as dollar peaks... the changes in foreign official holdings of USTs at the NY Fed in the six months following previous dollar peaks. Clearly, foreign official demand for TIPS increases after dollar peaks. The recent rally in rates combined with gradually changing inflation dynamics increases the possibility that we have already seen the peak in dollar strength. Historically, this would mean better demand from foreign officials for TIPS. At the very least, we believe the selling pressure would abate. This along with no 5y auctions in the first three months should create a positive demand environment for front end TIPS in Q1 2023.

 

“…TIPS demand from investment funds in 2023 would be completely driven by the macro environment. The biggest TIPS ETFs have seen outflows for most part of 2022 as breakevens started to drift lower from historically high levels and real rates drifted higher. Deteriorating risk sentiment created a huge demand from private investors for safe haven assets which would most likely continue into 2023. However, investors preferred nominals over TIPS due to high implied breakevens in an environment when central banks are actively trying to rein in inflation. We saw a similar dynamic in late 2018 and early 2019 when TIPS ETF flows turned negative towards the later stages of a hiking cycle... These flows only turned positive after 5y breakevens have reached as low as 1.5% and Fed began to cut rates. Considering the current inflation, breakevens close to 2% would make TIPS attractive over nominals and that might not be the case until second half of 2023.

 

“…Implications for IOTA spreads in 2023 - Prior to 2019, the Treasury auctioned 30y TIPS in October followed by 10y in November and 30y in December. So, the supply in the final quarter was spread evenly across the curve. However, in 2019, the Treasury replaced the 30y TIPS auction in October with a 5y TIPS auction. This increased the supply in the belly of the curve in Q4 with two 5y TIPS auctions in a span of 3 months and eliminated the long end supply in the final quarter. This supply imbalance combined with the foreign official sales in front end TIPS due to reasons explained above, lead to 5y breakevens underperforming relative to matched maturity inflation swaps. This led to 5s30s iota slope flattening over the last 3 months.... As a reminder, the IOTA spread is the difference between matched maturity inflation swaps and the breakevens….As previously mentioned, we expect a revival in foreign official demand for TIPS in 2023, as dollar weakens and 5y supply dries up in Q1. This should result in the steepening of the 5s30s IOTA slope.”