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BEs finally find a modicum of support as buyers return
In what can largely be described as the most mundane trading session of the week thus far, TIPS breakevens and inflation swaps spent much of the session skirting just beneath and above the surface in a relative choppy but narrow range today. And with the session quietly coming to a close, dealers are marking the inflation curves a modicum higher today (~ +0.75bps to +2.25bps) – in stark contrast to all the prior sessions this week – amid better buying, sources report.
“After struggling to gain any traction during the first part of the week, TIPS found a modicum of support today although the volumes remain far below average,” one dealer explained. “As such, it’s hard to place too much weight on the broader price action, especially ahead of the upcoming non-farm payrolls and then CPI next week,” he continued. Nevertheless, he noted that “there have been better buying flows these past two days.”
Elsewhere, in today’s Fed-speak, St. Louis Fed’s Bullard (and perennial hawk) stated that “we need to stay at it to get inflation back down to 2%” and that “inflation is going to be sticky going forward” are likely greasing the wheels for some of today’s curve flattening.
In derivatives-space, inflation swap on the SDR today included 1y ZC swaps at 272bps, 2y ZC swaps at 246.5bps, 20y ZC swaps at 239.125bps, 25y ZC swaps at 235.25bps, and 235.375bps, and 30y ZC swaps at 235.25bps, 235.625bps and 235.75bps (for all of today’s trades, see Total Derivatives SDR, which now also includes information on broker/platform).
Looking ahead, all eyes will be on the US CPI report for March next Wednesday (April 12th). It follows a downside surprise in the latest PCE report for February, as well as an array of weaker-than-expected data this week, with markets increasingly focusing on the growth outlook and the likelihood of a recession. Previewing the release, strategists at Deutsche Bank highlight the following:
- ”… Current futures pricing shows an even probability of a hike and a pause at the next Fed meeting on May 3rd. Markets are then pricing in more than 3 rate cuts by year end. So the CPI release will be important for whether this more dovish pricing is maintained. Our US economists see a +0.2% MoM increase for the headline rate (vs +0.4% in February) and +0.4% for core (+0.5%). Their recent report shows that despite the soft PCE data, trend inflation remains elevated.”
Heading into the final hour of trade, the 2y breakeven in the screens is seen at 261.5bps (+2.25bps), 5y at 238bps (+1bps), 10y at 224.75bps (+0.75bps) and 30y at 219.75bps (+1.25bps).
JP Morgan: Neutral on TIPS breakevens
Strategists at JP Morgan acknowledge that positive sentiment could drive TIPS breakevens somewhat wider over the near term, especially as macroeconomic data are likely to stay positive for now. However, the bank remains neutral on breakevens for the following reasons:
- ”…First, valuations no longer appear cheap…on a carry-adjusted basis, 5-year breakevens are trading wider than March 8 levels, when banking system stress started to come into focus, and are near the middle of the range they have held over the last few months. Additionally, breakevens continue to appear fairly valued after adjusting for broad commodity prices and credit spreads.
“…Second, while the risk of runs on regional banks has faded given the strong response of regulators, medium-term recession risks remain elevated, and banks of all sizes will likely continue to shore up liquidity, with negative implications for credit growth. Our economists note that the strong growth momentum to start the year and healthy household and corporate balance sheets should mitigate the economic effects of credit tightening to some extent, but nonetheless, they still estimate that reduced bank lending likely implies about a 0.8%-pt drag on real GDP growth over the coming year. While it may take time for the effects to show up in the economic data flow, bank earnings over the coming weeks may keep liquidity and profitability pressures in focus for investors. With equities and credit spreads pricing only a little more than 50% probability of recession over the coming year, we think risk assets have room to reprice lower if our growth forecasts come to fruition, which could it make it difficult for breakevens to widen materially from current levels.
“…Third, outflows from TIPS-focused ETFs have continued unabated in recent weeks, even as breakevens have rebounded. Meanwhile, from a broader perspective, we see that mutual fund flows have been almost entirely concentrated in Treasury-only funds and government MMFs, while equity and credit funds continue to record outflows (see Overview). Against a backdrop of elevated recession risks, we think investors are likely to retain a preference for liquid, high-quality assets, and we’re unlikely to see significant inflows into TIPS funds.
“…Fourth, reduced market liquidity and elevated volatility makes the TIPS market somewhat vulnerable. For now, liquidity conditions in the TIPS market appear to be worsening by some measures. As we noted last week, 5-year TIPS breakevens underperformed versus inflation swaps in the immediate aftermath of the SVB and Signature Bank failures, but the basis has reversed sharply over the past week to somewhat more normal levels….Our market depth proxy, calculated as average TIPS trading volumes relative to realized volatility in 10-year breakevens, which can be quite choppy, but on average, this measure rose sharply in February before declining once again in March. Additionally, dispersion along our real yield fitted curve has remained low, and we see little evidence of off-the-run liquidations. To some extent, TIPS are somewhat shielded from the recent bank liquidity pressures since US banks typically do not hold TIPS in their securities portfolios. Nonetheless, if the fundamental backdrop gradually deteriorates over coming months and broad market liquidity remains poor, we think it will be difficult for breakevens to retest their wides reached at the start of this month. Overall, given fair valuations and elevated medium-term recession risks, we remain neutral on breakevens.”