USDi: 10y Auction tailwinds continue to lift BEs

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10y Auction tailwinds continue to lift BEs

The tailwinds from last week’s stellar 10y TIPS market continued to propel the inflation market higher for the fourth consecutive session.  To be sure, the TIPS breakeven and inflation swaps curves were marked up another 1-4bps in the 2y-30y sector despite an stealthy yet ultimately impressive bull-flattening move in nominals (~3-8bps), lower energy prices (gasoline -1.92%, Brent -2.21%, WTI -1.78%) and a ho-hum risk backdrop (Dow +0.31%, S&P -0.7%, Nasdaq -0.27%). 

Reflecting on the recent bullish price action in the inflation market, one trader explained that the auction last week "lifted a burden on the market,” and without the heavy load of duration hanging over the market it’s been free to run higher. Similarly, another trader noted that recent price action has been “building on the post-auction rally that has now taken us almost 15bps off last week's lows” in the 10y breakeven.

Flow-wise, in derivatives-space, inflation swap trades on the SDR today included 1y ZC swaps at 225bps, 5y ZC swaps at 240bps, 240.5bps, 240.635bps, 240.875bps and 241bps, 6y ZC swaps at 243.75bps,  7y ZC swaps at 245.625bps, 10y ZC swaps at 248bps, 248.875bps, 248.75bps, 235.625bps and 243.75bps, 20y ZC swaps at 243bps and 30y ZC swaps at 243bps (for more trades, see Total Derivatives SDR).

Heading into the final hour, the 2y breakevens is going out at 232.875bps (+3.75bps), 5y at 223.25bps (+1bps), 10y at 228.25bps (+1.375bps) and 30y at 230bps (+1.625bps).

BofA: How likely is 2.25% inflation? Pay fixed on 1y inflation swap

While there are paths to the Fed’s favored 2.25% headline inflation by June, strategists at BofA think that “the likelihood of inflation falling that quickly is low.”  Indeed, the bank believes that “it will take time to rebalance the labor market and to see a sustained moderation in wage growth.” 

That said, if inflation were to fall that quickly, then BofA believes that  “it would likely mean the Fed would begin cutting rates earlier than we currently anticipate, specifically if the labor market cools enough for the Fed to have confidence that core services will not accelerate.”

Nevertheless, BofA believes that the odds of such a rapid fall in inflation are low and it finds that the front-end of the inflation swaps curve has gone too far.  The bank expounds below:

”…The market is pricing a fast and persistent drop in inflation which in our view is unlikely to materialize without a material growth shock in coming months. We think that the 1y inflation swap at 2.15% is likely to be challenged in coming months with a rebound in energy prices and core inflation that may prove more resilient. We recommend clients pay fixed on 1y inflation swap at 2.15%, targeting 2.5% with a stop of 1.95%. The key risks to the trade are that growth slows more quickly and/or that goods deflation evolves at a more rapid pace.

 

“…We think that the trade is a good way to hedge long duration exposure in portfolios, as a key risk to a long UST position is that the Fed ultimately needs to hike more or hold for longer than what is priced, a scenario underpinned by stronger inflation. For clients that want to fade the degree of cuts priced into 2H '23, playing for a higher inflation trajectory near term is also a way to express doubt in this outcome.”