USDi: BEs bounce a bit despite First Republic still circling the drain

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BEs bounce a bit despite First Republic still circling the drain

Unlike yesterday, nominals ultimately turned a blind eye to First Republic Bank’s circling of the drain today - the troubled bank losing an additional 30% in share value this session.  Indeed, with tech titans Microsoft and Google-parent Alphabet’s earnings helping to somewhat support broader risk sentiment today (Dow -0.68%, S&P -0.38%, Nasdaq +0.47%), nominals consolidated lower with yields rising roughly 3-5bps as the curve bear flattened. 

Against this backdrop, the inflation asset class fared much better today with only the front-end of the TIPS breakeven and inflation swaps curves slipping into negative territory again along with further weakness in the energy complex this session (gasoline -1.34%, Brent -3.74%, WTI -3.50%).   Whereas, longer tenors on the inflation curves managed to eke out modest gains today after a choppy but relatively contained trade. 

“Swings in duration mostly dictated the path for breakevens, with the net result a mostly in line performance with 5y and out a few bps higher while the front-end lagged late as energy finished poorly,” one dealer explained.  "Flows seen here generally reflected the price action with better sellers of the 5y and in sector as the day progressed, and mixed further out the curve,” he continued.

In derivatives-space, inflation swap trades on the SDR today included 1y ZC swaps at 236bps, 237bps and 237.75bps, 2y ZC swaps at 236.25bps and 237bps, 3y ZC swaps at 244.375bps, 5y ZC swaps at 248.125bps, 250bps and 251.5bps, and 10y ZC swaps at 254.125bps and 253.75bps (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 216.875bps (-2.625bps), 5y at 229.125bps (+1.625bps), 10y at 226.75bops (+1.875bps) and 30y at 225.125bps (+1.875bps).

Deutsche Bank: Inflation and Fed rate cuts

Deutsche Bank research this week highlights that the Fed rate cuts priced for next year - about 200bps for the entire 2024 - are expected to take place “while inflation is still relatively high and above the target.” In contrast, in the recent past, inflation had been "below or around the 2% threshold (and well below 3%)” when rates were cut, according to the bank. And this could be risky:

“If the Fed starts with rate cuts with high inflation, there is a risk that inflation might refuse to decline below its threshold and that, as a result, the long end of the curve begins to price in a higher inflation risk premium. This is precisely what  happened in the late 1980s.”

Still, looking a little further back the Fed has cut with inflation above 3% in living memory, for instance in the late 1980s:

“Between mid-1989 and mid-1990, 10s rose by about 100bp, from 7.8% to 8.8%. During that period, core CPI increased from 4.25% to 5.2% while economic activity continued to slow down.

 

“According to the economists’  forecast, by the end of this year, we could approach similar initial conditions as we had 35 years ago. This will be supportive for additional steepening of the curve that is not priced in by the current forwards. If rate cuts begin and short rate continues to decline as predicted, this would amount to an actual twist mode of the curve.”