Spread curve steeper - fade the move at the front end?
Treasuries have pared gains and yields sit just 1-2bps lower at the time of writing with the 30y at 3.66% (-2bps). In risk assets, S&P futures are 0.3% into the red ahead of the flash PMIs (the services index is seen edging up to 45.0 versus 44.7 last month), the Richmond Fed index and more corporate earnings reports. Earlier, the Philly fed non-manufacturing index rose to -6.5 from -12.8. In the news, the latest JPM Treasury Client survey recorded at small increase in the 'All clients' net short balance to -4% in the week to Jan 23 from -2%, while the 'Active clients' net short remained above the 2y average but increased to -11% from 0%.
Swap spreads are modestly tighter at the front end again today ahead of $42bn 2y auction with 2s at -2.00bps (-0.25), 5s are -23.75bps (-0.125), 10s are -31.75bps (+0.50) and 30s are -68.25bps (+1.00), while flows are a touch below average from the 5y bucket and further out.
Ahead, JP Morgan looks at the outlook for swap spreads following recent spread curve widening and long end outperformance.
It reckons 5y spreads widened on the back of slowing issuance after heavy supply in the first week of January, but suggests that the move is also the result of a declining dollar:
- “The trade-weighted dollar has become an important factor impacting swap spreads because of its impact on foreign demand for US Treasuries. Fed custody holdings of USTs (a proxy for foreign official demand) have closely tracked the trade-weighted dollar with a 6-week lag. Given the dollar's recent cheapening (itself the result of moderating Fed hiking expectations in recent weeks), this suggests that foreign official demand should remain supportive of wider swap spreads in the near term.”
Still, the bank finds that valuations are no longer favorable in the 5y sector, where spreads are reckoned to be close to fair value. JP Morgan adds that this is “in contrast to most other sectors, where swap spreads remain below fair value.”
Therefore, the bank turns “tactically neutral” in the 5y sector but remains “biased in favor of wider swap spreads across much of the curve.” In particular, it estimates that 2y spreads remain “narrow” to fair value (in contrast to some other banks – see Total Derivatives), while 3y swap spreads are “considerably wide” adjusted for the level of 2- and 5y spreads. JP Morgan concludes:
- “The 2s/3s spread curve (adjusted for the 2s/3s UST curve) has been well (and inversely) correlated to 2Y swap spreads and should flatten if front end spreads widen. Therefore, we recommend 2s/3s swap spread curve flatteners coupled with a 10% risk-weighted 2s/3s Treasury curve flattener to remove the 2s/3s curve exposure and isolate exposure to wider swap spreads”.
- MTB plans USD 3y, 5y and 11y NC10 bonds at around Treasuries +115, 145 and 190bps, respectively. Leads are Barclays, BofA (B&D) and MS.
- IFC is working on a 3y FRN Global via BofA, BMO and WFS. SOFR +28bps.