USDi: Markets squeeze dovish message out of Powell; BEs follow suit

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Markets squeeze dovish message out of Powell; BEs follow suit

Fed Chair Powell and his steadfast band of voting Fed officials did the best they could to engineer a ‘hawkish downshift’ today by unanimously raising the fed funds rate by a reduced 25bps - as was widely expected - while also signaling that the Fed’s bullet chamber remains fully loaded as “ongoing increases in the target range will be appropriate” to kill the inflation beast.  However, when Powell conceded in his presser that the “disinflation process has started,” that was essentially all the markets needed to hear today and then it was off to the races – even as Powell continued to push back on any rate cuts in 2023.

To be sure, after some initial bouts of volatility, nominals, equities and TIPS breakevens all either pared early losses or added to early gains as the markets ultimately squeezed a dovish message out of Powell’s comments.  And despite an up to 11bps drop in nominals yields in the wake of Powell’s comments, breakevens rose out of the pre-FOMC gutters to end modestly higher (~ 1-2bps) in the 2y-30y sector in the face of solidly lower energy prices (gasoline -4.04%, Brent -2.55%, WTI -2.45%).

“We went into the 2pm Fed at the lows of the day,” one dealer explained. “Then the press conference disinflation discourse gave risk assets a bid and TIPS were happy to tag along, which ultimately saved them from another ugly session,” he continued, referencing yesterday’s compression in breakevens despite the healthy month-end extension.

Flow-wise, in derivatives-space, inflation swap trades on the SDR today included 1y ZC swaps at 226.25bps and 220bps, 2y ZC swaps at 231.25bps, 231bps, 233bps and 224.5bps, 3y ZC swap at 235bps, 4y ZC swaps at 237.5bps, 5y ZC swaps at 241.625bps, 241.75bps and 241.25bps 10y ZC swaps art 246.625bps, 15y ZC swaps at 245.125bps, and 20y ZC swaps at 241.5bps (for more trades, see Total Derivatives SDR, which now also includes information on broker/platform).

Lastly, at the quarterly refunding announcement this morning, Treasury confirmed that the February 30y TIPS auction will be $9bn, the March 10y reopening will be for $15bn, and the April 5y new-issue will be for $21bn.  Treasury also stated that it will continue to monitor TIPS market conditions and consider whether modest changes would be appropriate in future quarters.  See here for the full refunding announcement.

Heading into the final hour of trade, the 2y breakeven is going out at 235bps (+1.875bps), 5y at 234.25bps (+1.5bps), 10y at 225.625bps (+1bps) and 30y at 223.25bps (1.5bps).

JP Morgan: Favor 1Yx1Y inflation swap longs

Over the near term, strategists at JP Morgan remain “cautious that hawkish jawboning from the Fed combined with weakening corporate earnings and rich valuations in risk assets means markets are vulnerable to worsening risk sentiment before we reach the end of the tightening cycle.”  In that environment, the bank thinks that “we would likely see breakevens retesting their lows, if not falling further.”

However, JP Morgan thinks that “longs in 1Yx1Y inflation swaps are an attractive way to position for a medium-term bullish view,” noting that “importantly, this part of the curve has demonstrated a lower beta to risk assets compared to benchmark breakevens, and the sector has lagged in the recent bounce:…1Yx1Y swaps remain only about 9bp above their narrowest levels reached last week, while the intermediate sector has led the move, with 5Yx5Y swaps 15bp wider and near their top end of their two-month range.”

Moreover, JP Morgan finds that “the sector also remains significantly cheap versus commodity prices,” and believes that “forward inflation swaps offer an attractive opportunity to position for medium-term richening while avoiding the  highly punitive carry profile of spot breakeven wideners.”

Hence, JP Morgan recommends “initiating 1Yx1Y inflation swap longs”.