USD Swaps: No sigh of relief for banks just yet; A steepening conviction

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No sigh of relief for banks just yet; A steepening conviction

That long-awaited sigh of relief once again proved difficult this week as rate volatility persisted in the face of continued angst about the global financial/banking system.  And this concern over banks has continued into the weekend as bank CDS and banking shares (e.g. Deutsche Bank)  – while off their worst levels of the day – are still showing signs of uneasiness.   

Against this backdrop, the major domestic equity indices are mixed but little changed in the early afternoon trade (Dow +0.04$, S&P +0.05%, Nasdaq -0.25%), while Brent futures are $0.88 (-1.11%) lower.  Meanwhile, Treasuries remain in bull-steepening mode but this morning’s stronger-than-expected S&P Global Composite PMI (+53.8 versus +49.5 Bloomberg consensus) helped take some wind out the sails. 

Currently, the benchmark 2y note yield is 8.9bps lower at 3.744% after hitting a low water mark of 3.5531% in the early trade today.  On the curve, the 2s10s spread is another 1.25bps wider at -40bps with more dealers now seeing curve steepening as the new market craze (see Deutsche Bank below).  And assessing the broader price action in rates this week, one source grumbled that “volatility remained the only reliable trend”.

SOFR futures have come well off their morning highs with the reds and greens currently just 1.54 to 4 ticks firmer while first IMM FRA-OIS is last 3.3bps wider at 44.5bps.  And swap spreads mixed amid varying levels of activity, best seen at the 5y and 10y tenors today.  In the backdrop, IG issuance is offline today as the ongoing concerns about the banking sector keep issuers sidelined.

Ahead (and independently) of the recent banking stresses and this week’s FOMC decision, strategists at Deutsche Bank argued that the rates market was approaching a turning point and they exited their remaining outright bearish trade and made the case for UST2s10s steepeners as the next strategic trade, with 100bp+ upside.   The bank explains that:

”…The strategic case for the trade was based on our expectation of broad-based tightening in bank lending standards that will weigh on growth and inflation and limit upside risks to the terminal rate. From a tactical perspective, we noted the FOMC would move away from overly explicit forward guidance, which would limit the tightening priced for the May meeting and beyond and thus the downside risks to the steepener. Finally, we noted that the main risk to the trade would come from an upside surprise in terms of government support for banks (e.g., a blanket deposit guarantee), which we saw as unlikely to come preemptively.”

And after this week’s FOMC decision, Deutsche Bank has even more conviction in the trade for the following reasons:

”…First, the FOMC statement and Chair Powell noted that recent developments are likely to tighten credit conditions and weigh on activity, hiring, and inflation. Most of the press conference focused on the potential implications of recent turmoil, and Chair Powell noted that tighter credit conditions will act as a substitute for further policy tightening.

 

“…Second, the Committee softened and dovishly revised its forward guidance, replacing ‘ongoing increases are likely’ with ‘some firming may be appropriate.’ In repeatedly referencing elevated uncertainty around credit tightening and connecting it to the appropriate policy stance, the Chair also implicitly watered down the signal to be taken from the SEP dots. The market clearly reacted to these communications, with May OIS now pricing only ~10bp of hikes followed by cuts starting in June.

 

“…Third, the Chair (and Secretary Yellen) reinforced our view that a blanket bank deposit guarantee won’t come preemptively. Importantly, the Chair did note more than once that “all depositors’ savings are safe.” But his remarks did nothing to move our views on the likelihood of preemptive action. More importantly, in Congressional testimony today, Secretary Yellen stated, “I have not considered or discussed anything having to do with blanket insurance or guarantee of deposits.” We still think the Fed, Treasury and FDIC would act on a temporary basis without Congressional approval if necessary (using the ESF), but the hurdle to this is clearly very high and it would take more turmoil for it to come about."

Hence, all told, Deutsche Bank’s conviction in the steepener has steepened, and it thus continues to favor its original trade:

“…We enter a UST 3m forward 2s10s steepener (target +10bp, stop -70bp). We prefer to express the steepener in Treasuries, noting that front-end swap spreads underperformed during last week’s banking turmoil, likely driven by banks liquidating short-dated Treasuries to raise cash (the large repricing of Fed hikes also gave banks an attractive window to do so). Since then, the substantial rise in bank reserves, increases in money market fund AUM, and potential for tougher regulations around liquidity requirements for regional banks are all positive factors for the recovery of front-end swap spreads. While we are also modestly bullish on intermediate and long-end spreads, the risk has increased that banks will be required by regulators to hold more capital and strengthen their balance sheets going forward, which would tend to have a bigger negative effect on longer-dated spreads. Taken together, this suggests that a steepening of the yield curve would be larger in cash than in swaps.”

Currently, SOFR swaps – 2s -0.25bps (+1.375bps), 3s -12bps (+0.625bps), 5s -21.625bps (-0.75bps), 7s -29.625bps (-0.375bps), 10s -29.5bps (-0.125bps), 20s -68.625bps (+0.625bps), 30s -75.25bps (-0.625bps).