USDi: BEs get modest bump up after solid 10y TIPS reopening

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BEs get modest bump up after solid 10y TIPS reopening

Today’s $15bn 10y TIPS re-opening once again proved that investors still hanker inflation protection. To be sure, the second coming of the Jan33s stopped roughly 1.5bps through the 1pm market, drawing a stop-out yield of 1.395% and a respectable 2.31x bid-to cover ratio.  Indict bidders took down 76.4% of the issue while directs claimed 15.9%, leaving dealers with a 7.7% odd-lot - their second smallest allocation on record. 

After a strong opening bid and a rather choppy trade afterwards, breakevens went into today’s auction modestly bid against the backdrop of another sell-off in nominals (~5-10bps)  owing largely to (1) news that House Speaker McCarthy finally sees a debt-limit deal coming to the floor for a vote next week as negotiations are in a “much better place”, and (2) today’s batch of stronger-than-expected to consensus data (i.e. jobless claims, Philly Fed, existing home sales, leading index). 

And once the auction results hit the tape, breakevens got another bump higher followed by another choppy trade into the close. So, with the dust settling on today’s trade, dealers are marking breakevens roughly 2-3bps higher in the 2y-30y sector as the curve modestly extended its bull-flattening run despite a retreat in oil prices (Brent -1.20%, WTI -1.11%).

“The persistent real yield selloff all morning made certain that the auction was well-attended,” one trader explained.  “The breakeven path throughout the day was a volatile one with several lurches in either direction with the 3pm levels ultimately very close to unchanged on the day,” he continued, noting that his desk saw good buying into the auction and mixed flows afterwards.

In derivatives-space, inflation swap trades on the SDR today included 2y ZC swaps at 233.258bps and  233.5bps, and 5y ZC swaps at 240bps  (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 208.25bps (+3bps), 5y at 217.375bps (+2.125bps), 10y at 224.25bps (+1.875bps) and 30y at 228.75bps (+1.75bps).

BofA: Less than Great Expectations; Long 1y inflation swap

The market is currently pricing around 50 bps of rate cuts over the second half of the year alongside YoY CPI declining to below 3% YoY in Q4. But, both the extent of rate cuts and sharp decline in inflation stand at odds with what the economics team at BofA and Bloomberg consensus expect. 

BofA also believes that “the recent compression in the spread between inflation and nominal rates to surveys suggests that the market is likely assigning a fair amount of downside risk to the base case,” which “may be due to debt limit and banking sector concerns.” 

Should these fears abate, BofA would expect the wedge between market pricing and expectations to also moderate, and it favors monetizing its view with a long 1y inflation swap.  It expounds:

”…Inflation wedge demonstrates cyclicality - We find that the gap between market pricing of inflation and modal expectations is generally cyclical. In periods when the economy is slowing as evidenced in PMIs, the wedge tends to be more negative. Similarly, periods of poor equity performance also correspond with a lower wedge. We see more of this cyclicality evidenced in the fluctuations of the market pricing of inflation vs surveys than nominal rates vs surveys. In part this may be because inflation swaps are sensitive to fluctuations in oil prices which have a pro-cyclical component that surveys are not responsive to in real time.

 

“…Market tends to underestimate the Fed and inflation - Historically, the market tends to underestimate actual Fed policy ahead of both hiking and cutting cycles: the market often prices too few rate cuts ahead of a cutting cycle and too few hikes ahead of a hiking cycle. This suggests that if the Fed does begin a cutting cycle later next year as our economists expect, the Fed may deliver more cuts than what is currently priced one year ahead. The market also tends to underestimate inflation 1y out. Inflation swaps adjusted for the lag in the CPI index have underpriced realized inflation about 65% of the time since 2008.

 

“…1y inflation swap better way to fade front-end decline - Going long 1y inflation swap for investors with a longer-term time horizon may be the preferred way to fade recent moves. Inflation swaps appear to offer better asymmetry vs nominals historically. We are wary of market volatility in coming weeks which may drive market pricing of inflation further from modal expectations. However, should risks around the debt limit and banking stress abate, the front end of the inflation market has room to reprice higher.”