USDi: Front-end remains the sweet spot for BEs; 5y TIPS auction preview

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Front-end remains the sweet spot for BEs

USD inflation had a somewhat soggy but relatively humdrum trading session today.  To be sure, outside of the outperforming 2y sector, TIPS breakevens softened up a touch (~ 1-2bps) against the backdrop a mixed but tightly coiled trade for risk assets as well as the energy spectrum (Dow -0.03%, S&P +0.09%, Nasdaq -0.04%, gasoline -0.83%, Brent -0.05%, WTI -0.07%) and an up to 3bps drop in nominal yields.  

Beside the continued barrage of corporate earnings releases (Bank of America, BNY Mellon, J&J, and Lockheed Martin posted strong results, while Goldman Sachs was the lone soft report), market participants also had come hawkish blurbs from St. Louis Fed President Bullard (…favoring continued rate hikes & supporting a 5.5% to 5.75% terminal rate) and more balanced blurbs from Atlanta Fed President Bostic (... favoring one more hike then a pause) to chew on today -  but little else of quench the appetite this session.

Notably, the front-end continued to enjoy better support today compared to longer tenors with one trader suggesting that the front-end is “likely the sector end-users feel most comfortable owning given the shifting macroeconomic backdrop.”  That said, he noted that “the 5y supply later in the week could keep that momentum from gaining too much traction these next few days.”  See below for a 5y TIPS auction preview.

In derivatives-space, some of the chunkier tickets printed in inflation swap on the SDR today included $100m 1y ZC swaps at 253bps, a total of $240m (2 x $120m) 2y ZC swaps at 244.5bps, $180m 3y ZC swaps at 245bps,  and a total of $150m (2 x $50m & 2x $25m) 5y ZC swap (for all of today’s trades, see Total Derivatives SDR, which now also includes information on broker/platform).

Heading into the final hour of trade, the 2y breakeven is going out at 253.625bps (+1.875bps), 5y at 240.75bps (-0.5bps), 10y at 228.75bps (-2.25bps) and 30y at 26.75bps (-2bps).

Citi: 5y auction likely to attract strong demand; 5y IOTA spread tightener

Strategists at Citigroup believe that this week’s 5y TIPS auction will attract strong demand from end-users and they favor 5y IOTA spread tighteners heading into the auction.  Citi expounds below:

”…Historically, new-issue 5y TIPS auctions in April have traded through the when-issued level. The new-issue 5yr TIPS, i.e., 1.125 Apr28s, will be auctioned next week on Thursday April 20th. The roll to the current OTR 5y TIPS, the Oct27s is currently trading at 6.1bp (as of 12PM on Friday, 14 April 2023). Typically, new-issue 5y TIPS auctions have performed well in recent years. In fact, each of the last 7 April new-issue 5y TIPS auctions have traded through the when-issued level by an average of 1.5bps. We expect this trend to continue as we expect a pickup in demand from investment funds.  The 10y TIPS auction in March also tailed the when-issued yield. However, 30y and 10y TIPS auction performance have not been good predictors of 5y TIPS auctions recently. For example, in 2022, 30y and 10y TIPS auctions in Feb and March both tailed by 6.5bp and 2.1bp, respectively. But the 5y new-issue auction in April traded through the when-issued yield by -4.5bp. We think the main difference is that the demand from investor funds tends to be higher in the 5y sector than in 10y or 30y sectors.  (Looking at) the average percentage takedown by investor funds in new issue TIPS auctions since 2017 -  Investor fund takedown is the highest in 5y TIPS auctions at ~73% followed by 65% in 10y auctions and 62.5% in 30y auctions. This excess demand from investor funds is most likely the driving force behind the strong 5y new issue TIPS auctions.

 

“…Flows into TIPS funds tend to bottom around the last rate hike. Both short- and longer-term TIPS funds have seen outflows in recent months as investors scaled back their exposure to real yields during the hiking cycle. This is not something unique to this cycle. (Looking at) the rolling 2y z-scores of monthly flows into various bond funds… - During the last two hiking cycles, investors have reduced their allocation to inflation-protected bonds. The inflows tend to bottom around the last hike and typically pick up as Treasuries start to rally into the first cut. The combined flows into all taxable bond funds also tend to increase after the last hike as investors start to add duration risk to their portfolios before the rate cuts. So, we expect investor demand for TIPS to improve over the next few months as we move closer to the end of the hiking cycle.

 

“…We like our 5y IOTA spread tightener heading into the auction (this)t week. The demand from investor funds for 5y TIPS is not just limited to the day of the new-issue auction. Historically, the 5y IOTA spread has tightened (i.e., 5y breakevens have outperformed the matched maturity inflation swaps) both heading into and coming out of the strong auctions. In Figure 14, we show the changes in the OTR 5y IOTA spread in the two-week period starting 1 week before the auction in the last 7 years. The spread has tightened every year and on average it tightened by about 4.5bp during this period. So, we continue to recommend our 5y IOTA spread tightener which is currently trading at 25bp (we entered the trade at 26b). The trade has a carry of +7.5bp over the next year.”