USDi: BEs weather latest debt impasse well
Click here for SDR inflation swap trade
BEs weather latest debt impasse well
That debt ceiling impasse dragged on for yet another day, remaining a pesky thorn in the side of the broader financial landscape today. Indeed, news that Biden and McCarthy continued to butt heads on raising the debt ceiling sent equities lower today (Dow -0.61%, S&P -0.97%, Nasdaq -1.19%) while an early sell-off in nominals reverted back to largely unchanged levels on the day beyond the underperforming front-end.
Meanwhile, away for the debt ceiling, Minneapolis Fed President Kashkari hinted at ‘higher for longer’ this morning, stating that “if inflation stays high, if inflation became more entrenched that we realized then we’re going to have to keep interest rates high for longer and that’s going to increase the pressure on the banking sector.”
However, the U.S. inflation asset class managed to weather the latest failed/stalled iteration in debt limits talks and today’s hawk-talk relatively well as the energy complex got another lift (gasoline +0.71%, Brent +1.38%, WTI +144%) amid supply/demand concerns, helping the TIPS breakeven and inflation swaps curves to bull-flatten today.
In derivatives-space, inflation swap trades on the SDR today included 1y ZC swaps at 236bps and 235bps, 2y ZC swaps at 237.5bps, 236.5bps, and 238bps, 3y ZC swaps at 239.625bps, 5y ZC swaps at 247bps, 248.875bps, and 247.25bps, 15y ZC swaps at 252bps and 20y ZC swaps at 248.875bps likely as a 15s20s switch (for all of today’s trades, see Total Derivatives SDR, which now also includes information on broker/platform).
Heading into the last hour of trade, the 2y breakeven is going out at 214bps (+6bps), 5y at 221.875bps (+3.5bps), 10y at 228.375bps (+3.25bps) and 30y at 232.875bps (+2.75bps).
JP Morgan: Maintain 2y3y breakeven narrowers
Strategists at JP Morgan believe that “macro developments particularly related to the debt ceiling are likely to be the primary driver of breakevens over the near term.” Specifically, the bank believes that “a timely resolution by Congress should push breakevens wider, as market turmoil and the associated economic fallout are avoided,” but it continues to argue that “any widening on the back of a deal is likely to be concentrated at the front end of the curve.”
Indeed, comparing inflation swap rates across various forward points, JP Morgan finds that “a significant discount appears to be priced in out to the 2-year maturity point, with 1Y and 1Yx1Y swaps trading close to 230bp, below most professional forecasts for inflation. Meanwhile, the rest of the forward curve has remained fairly well anchored, with 2Yx3Y and 5Yx5Y at 251bp and 258bp, respectively, in line with slightly above target PCE inflation, assuming a reversion in the CPI-PCE wedge toward historical averages.”
Away from US debt ceiling developments, JP Morgan fins that “the front end has been dragged lower by weakness in commodity markets as well, with Brent oil prices in particular falling 13% over the last four weeks to $77/bbl, $8/bbl cheap relative to our commodity strategists fair value model. They highlight that with demand resilient and global oil supply set to start falling as OPEC+ cuts take effect, Brent prices are likely to rise above $90/bbl in the third quarter.” And in the bank’s view, “these dynamics are likely to support further breakeven widening into the summer under our baseline forecasts, especially as the front end of the curve continues price a modest discount on a cross-market basis.”
However, JP Morgan cautions that downside risks remain sizable:
- ”…. Even though concerns around default have been tempered this week, timing is still tight, with the two sides still negotiating, and Treasury likely to run out of resources by June 7 (our own forecast), or potentially as early as June 1. Thus, if momentum towards a deal stalls over the next couple of weeks, risk sentiment could deteriorate. Moreover, even if resolution is reached, we continue to believe the economy is headed toward recession, and a number of late cycle dynamics continue to limit the upside for risk assets and inflation expectations. In addition to shrinking profit margins and gradually softening labor demand, lending is contracting, primarily from regional banks, and a more rapid contraction of credit alongside further bank failures remains an important risk. Inflation is trending lower, and this should keep demand weak relative to nominal Treasuries….TIPS-focused funds have recorded $9bnfoutlws YTD, while Treasury funds have recorded $63bn of inflows.”
Overall, JP Morgan continues “to recommend positioning for narrowing further out on the term structure,” which it thinks “offers an asymmetric, relative value opportunity at current levels.” Given the dynamic discussed above,…the sector remains 14bp too wide relative to 1Yx1Y.” Thus, the bank continues “to recommend 2Yx3Y breakeven narrowers constructed via a notional-neutral combination of Apr-25 and Apr-28 TIPS.”