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BEs continue to sail smoother waters higher
The U.S. inflation market continued to sail calmer – and beneficial - waters this session as the normalization (?) of the financial/banking sector continued in stride today. Indeed, the banking sector remained on the mends today with the KBW Bank Index rising another +2.08% while recent ugly ducklings like First Republic Bank and Deutsche Bank rose +5.63% and +3.01%, respectively.
With this, the broader markets also rallied (Dow +1%, S&P +1.42%, Nasdaq +1.79%) while nominals chopped around to ultimately end up narrowly mixed (~+/-1bps). And against this backdrop, dealers markets breakevens and inflation swaps another ~2-6bps higher in the 2y-30y sector despite a pull-back in energy prices today (gasoline -1.74%, Brent -0.5%, WTI -0.42%).
“Breakevens jumped out of the gates with the first trade in the brokers going through almost 4bps higher than yesterday's closes, and while that proved to be close to the highs of the day the overall bid tone and outperformance versus the nominal move remained stout,” one dealer explained. “We saw better buying early in the session but a healthy mix as the day wore on,” he continued.
In derivatives-space, inflation swap on the SDR today included 1y ZC swaps at 274bps, 5y ZC swaps at 257.625bps, 256.375bps, and 256.75bps, 10y ZC swap at 257.625bps, 20y ZC swaps at 247bps and 247.25bps, and 30y ZC swaps at 242.75bps (for all of today’s trades, see Total Derivatives SDR, which now also includes information on broker/platform).
Looking ahead, the data highlight this week will likely be Friday’s core PCE reading; Barclays expects it to come in at 0.3% m/m, softer than the core CPI’s 0.5% m/m print because of compositional and data source differences. Friday is also month-end; Bloomberg estimates that the duration of the Series-B and L 1-30y TIPS indices will extend by 0.02% and 0.03%, respectively.
Heading into the final hour of trade, the 2y breakeven in the screens in quoted at 271.625bps (+3.375bps), 5y at 246.125bps (+5.75bps), 10y at 233.375bps (+3.25bps) and 30y at 228.125bps (+2.625bps).
BofA: Front-end risk for BEs more two-sided
Alongside the sharp bull steepening of the nominal rates curve in recent weeks, the inflation curve reflects lower inflation compensation at the front end. While fading the move lower in inflation breakevens (B/Es) may be tempting given attractive carry environment and potentially lagged impact of banking sector tightening on inflation data, strategists at BofA view risks at the front end as more two-sided. The bank expounds below:
- ”…The front-end of the inflation curve has shifted notably lower since the start of recent bank stress events, particularly at the 1y and 1y1y points. The move at the shorter tenors exceeds the historical relationship with oil prices, which suggests that the market is likely assigning higher risk to harder landing scenarios given the anticipated tightening in lending standards and eventual impact on loan growth. The low point of the inflation curve at 1y1y is generally consistent with our US economics team's recent note which suggests that the effects of tighter lending standards is felt over 6-10 quarters.
“…Over the past week, client interest has focused on whether to fade the declines at the front-end of the inflation curve. We currently see two-way risk around current levels. On one hand, the impact of a potential shift in bank lending behavior will take time to materialize in the inflation data. Last week our US economists modestly revised higher CPI by a tenth in both 4Q '23 and '24 to 3.4% YoY and 2.4% YoY, respectively.
“…Carry for long TIPS and BE positions is also attractive right now over a 6-month holding period. Three-month carry for the on-the-run 5y breakeven is 25bps, which at a current level of 2.35%, means that the breakeven rate can fall to 2.10% before an investor incurs losses on the position.
“…However, we think it is hard to say that breakevens, particularly at the front-end do not have room to fall further if the data deteriorates in coming months. Market sentiment still appears to be highly sensitive to concerns around banking risk events; Secretary Yellen's comments on Wednesday suggesting that Treasury is not considering insuring all bank deposits likely contributed to the reversal of the rally in BEs following the FOMC events.
“…Historically when lending standards tighten to the degree they did in January (most recent survey +45 on C&I loans for large/ medium businesses), 2y and 10y BEs have been below 2%. As Powell noted in the press conference this week, we do not know how much lending standards have tightened in real time, but "it could easily have a significant macroeconomic effect." If lending standards do indeed tighten further, history would suggest that spot breakevens, particularly at the front end, are biased lower.
“…The market pricing of near-term inflation is also at levels that present less asymmetry than when we recommended paying fixed on 1y inflation swap on 23 January. 1y inflation swap at around 2.7% is only about 15bps below where our Econ team expects YoY inflation to print over Q1 '24. With our econ team's base case for a recession starting in Q3 and risks now skewed towards a harder landing, we are cautious to recommend fading the recent decline in front end inflation compensation.”