USDi: BEs face steep uphill battle as banks angst returns

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BEs face steep uphill battle as banks angst returns

Wary investors continued to run for cover in the wake of First Republic Bank’s recent demise with more regional banks (...notably PacWest Bancorp and Western Alliance Bancorp) facing withering investor confidence today with banking shares in rapid retreat today.  And this once again spilled into the broader investor psyche this session with all the major domestic equity indices inflicted with losses today (Dow -1.08%, S&P -1.16%, Nasdaq -1.08%). 

Add in the subsequent 10-17bps bull steepening in nominals, another round of weaker-than-expected data (i.e. JOLTS, factory orders) and hemorrhaging energy prices (gasoline -4.27%, Brent -4.88%, WTI -5.14%) and it was indeed a steep uphill battle for U.S inflation asset class – one that it not surprisingly lost.   Indeed, TIPS breakevens and inflation swaps are closing out the session near their session lows as both inflation curves bear-steepened today.

"The combination of the outsized duration rally and energy selloff did not bode well for breakevens, and that scenario played out especially via a mid-morning rinse that set the tone for the rest of the day,” one dealer explained.  “The end result outright wasn’t too extraordinary given those moves in other markets,” he continued, noting that “flows reflected that dynamic with consistent selling in the 5y point specifically, while the front-end found a bit of buying interest towards the end of the day, similar to yesterday.”

In derivatives-space, inflation swap trades on the SDR today included 1y ZC swaps at 233.5bps, 2y ZC swaps at 228.5bps, 3y ZC swaps at 235.25bps, 5y ZC swaps at 246bps, 246.625bps, 247.625bps, 245.125bps and 243bps, 7y ZC swaps at 247bps and 246.75bps, 8y ZC swaps at 249.375bps, 10y ZC swaps at 249.625bps, 248bps and 248.25bps, 25y ZC swaps at 238.875bps and 30y ZC swaps at 239.25bps (for all of today’s trades, see Total Derivatives SDR, which now also includes information on broker/platform).

Looking ahead, for Fed meeting tomorrow the market is pricing a high likelihood of a 25bp hike, and later this week, the April employment report is released Friday, where Bloomberg consensus is expecting a +180k in headline payrolls.

Heading into the final hour of trade, the 2y breakeven is going out at 209.75bps (-6.875bps), 5y at 219.375bps (-6.5bps), 10y at 219.375bps (-5.125bps) and 30y at 219bps (-4.25bps).

BofA: TIPS for the final hike

The Fed will deliver the last rate hike of the cycle tomorrow according to the US Econ team at BofA and market consensus. When looking at prior cycles, BofA finds that “a Fed subsequently ‘on hold’ has clear implications for nominals: go long duration. 10y rates historically rally more than forwards currently imply following the last rate hike.”

Below BofA examines three reasons clients should consider long duration trades in TIPS vs nominals: 1) positioning may be cleaner, 2) carry likely less penalizing, 3) end of hiking cycle will likely be conditional on inflation, which can be better expressed through TIPS. The bank recommends clients go long the 1y1y real rate and it holds its long 30y TIPS view:

”…End of hiking cycle in TIPS/ BE/ Nominals - In the 12 months following the last rate hike, real yields tend to move within 20bps of nominals, suggesting that there has historically not been a material benefit to being long TIPS vs nominal rates from a duration perspective. This cycle could be different if inflation compensation is stickier while the market prices an easier Fed policy path.

 

BEs across the curve are already consistent with the Fed's target, but the market is still pricing a relatively aggressive policy setting in forward real yields. To us this presents some asymmetry and leads us to prefer long expressions in real yields, as stickier inflation vs what the market is pricing remains a material risk.

 

“…Positioning and carry benefits vs nominals - We do not have as clear indicators to gauge positioning in TIPS, but one way to proxy for this is through fund flows. Flows into UST funds have accelerated while inflation protected funds have seen steady outflows. This suggests that TIPS have likely not seen the same extent of demand in recent months and longs may be less crowded.

 

Our US Econ team is expecting modestly stickier inflation than the market is pricing through the end of '24. This helps support a more favorable carry profile in TIPS vs nominals over the next 12m. Effectively, real yields need to rally less for an investor to make money vs nominals, assuming our US Econ team's inflation forecasts materialize.

 

“…End of cycle trades conditional on inflation outlook - 1y1y inflation swaps pricing 2.3% is relatively consistent with how our Econ team expects inflation to converge. However, we would expect the Fed to be at a less restrictive rate than what the market reflects when inflation falls back towards target. We recommend clients go long the 1y1y real rate: buying 2y TIPS and selling 1y TIPS with April maturities in equal dollar amounts. In risk adjusted terms, investors are exposed to -49% of the 1y TIPS and 100% of 2y TIPS.

 

Current entry is at an implied rate spread of 61bps (1y1y forward real rate of 119bps). We target a spread of 30bps (1y1y 60bps) and stop out of 75bps (1y1y 150bps).”