USD Swaps: NFP an earsplitting wake-up call for UST bulls; Spread view

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NFP an earsplitting wake-up call for UST bulls; Spread view

Today’s January non-farms payrolls release served as an earsplitting wake-up call for recession-mongers, bond-market bulls and any remaining FOMC doves out there.  To be sure, the U.S. economy created – many – more jobs than even the rosiest of predictions with a headline print of a whopping +517k (versus +188k Bloomberg consensus) along with +71k of upward revisions to prior months.  Meanwhile, the unemployment rate unexpectedly ticked up one-tenth to 3.4% (versus 3.6% consensus) – leaving the rate at its lowest level in over half a century.  “Disinflation may have begun, but the still hot labor market may make it a bit too sticky for the Fed to stomach,” one source aptly quipped. 

And with this print coming off the back of an uber-dovish week for the Fed – along with the BOE and ECB – it comes as no surprise that this week’s bond-market rally has been utterly stopped in its tracks and summarily reversed this session.   To be sure, the benchmark 10y note yield has ricocheted 12.1bps higher to 3.514% while the 2s10s spread has compressed 3.5bps to -75bps as the front-end bears the brunt of the pain today.  Indeed, red and green SOFR futures have been knocked back 16.5 to 23 ticks as some dovishness/bullishness gets wrung out of the market today.

In swaps, spreads are mostly tighter against the sharp rise in underlying rates with SOFR volumes running at a mixed clip across the curve.   Bigger picture, despite today’s tightening in swap spreads, spreads are modestly wider across much of the curve this week except at the very front-end where strategists at JP Morgan believe that the recent narrowing “likely reflects a continued downshift in RRP balances from year-end peak levels - indeed, the 2bp narrowing in 2Y swap spreads since year-end 2022 is roughly consistent with the $300bn reduction in RRP balances, given our partial beta  estimate of about 0.4 - 0.5bp per $100bn RRP reduction.”   However, going forward, JP Morgan favors front-end spread wideners which it expounds on below along with its view on longer tenor swap spreads as well:

”…Going forward, we expect RRP balances to stabilize, which should help stabilize 2Y swap spreads as well. Indeed, as the stabilization in RRP balances plays out, it is likely that front end swap spreads will revert towards fair value, which we see as about 5bp wider from current levels in the 2Y sector. Therefore, we remain biased in favor of front-end swap spread wideners. We also recommend maintaining 2s/3s spread curve flatteners, which are likely well positioned to benefit from a widening in 2Y swap spreads.

 

“…Further out the curve, the YTD widening in long end spreads has been noteworthy. For instance, 20- and 30-year swap spreads have widened by 11bp since the end of last year. Much of this reflects moves in the underlying drivers themselves, as opposed to a reversion to fair value. In particular, the sharp weakening in the dollar in January has been the predominant driver behind the widening in long end spreads, as suggested by our fair value for 30-year SOFR maturity matched swap spreads...But with the dollar now stabilizing since mid-January, long end spread widening may have run its course in the near term. Therefore, we now turn neutral on 30-year swap spreads.

 

“…Swap spreads in the 20-year sector, however, continue to appear wide in relation to the level of 10- and 30-year swap spreads, and offer an attractive spot for spread narrowing exposure. One way to see this is to look at the 20s/30s maturity matched swap spread curve, adjusted for the level of 30-year swap spreads (which we are now neutral on) and the 20s/30s Treasury curve (which our Treasury strategists expect to flatten going forward)…This spread curve now appears too flat adjusted for these drivers and should be biased asymmetrically steeper if the 20s/30s Treasury curve flattens as we expect. Therefore, we recommend a 100:70 weighted 20s/30s swap spread curve steepener.”

Currently, SOFR swaps -  2s 1.625s (-0.625bps), 3s -10.875bps (-0.125bps), 5s -20.25bps (-0.375bps), 7s -28.75bps (-0.5bps), 10s -28.75bps (-0.375bps), 20s -57.375bps (-1.625bps), 30s -64.25bps (-1bps).