USDi: BEs sulk into month-end; Basis better bid

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BEs sulk into month-end; Basis better bid

While nervous optimism on putting the debt ceiling quagmire in the rearview mirror continued to brew in the backdrop today, a roughly 3-7bps rally in nominals into today’s month-end bid, lower energy prices (gasoline -1.39%, Brent -1.61%, WTI -2.09%), and growing angst over further Fed rate hikes after this morning’s JOLTS data saw job openings unexpectedly jolting up to a much higher than expected 10,103k (versus Bloomberg consensus 9,400k, prior 9,590k) all weighed on the U.S. inflation asset class this session.

Throw in today’s corresponding souring in risk sentiment (Dow -0.41%, S&P -0.61%, Nasdaq -0.63%), and dealers were marking TIPS breakevens and inflation swaps roughly 2-5bps lower in the 2y-30y sector today against a rather modesty month-end extension for TIPS (see below).  Separately, in derivatives-space, dealers cited a better bid to the inflation basis in recent sessions “denoting some buying on zero-coupon swap,” one trader explained. 

Flow-wise in derivatives-space, inflation swap trades on the SDR today included 1y ZC swaps at 230bps, 2y ZC swaps 232bps, 5y ZC swaps at 243bps and 241.375bps, and 30y ZC swaps at 245.125bps (for all of today’s trades, see Total Derivatives SDR, which now also includes information on broker/platform).

Elsewhere, this afternoon’s Fed’s Beige Book saw a “slower pace” of employment increases and a moderate increase in prices, “though the rate of increases slowed in many districts” while economic activity was “little changed overall.”

As for Fed speak, remarks skewed towards a conditional pause. Fed Reserve Governor Jefferson (voter) said that “skipping a rate hike at the coming meeting would allow the Committee to see more data before making decisions about the extent of additional policy firming” and explained that a pause “should not be interpreted to mean that we have reached the peak rate for this cycle.”

Philly Fed’s Harker (voter) comments followed shortly thereafter, and was direct, and said the Fed should skip a hike at the June meeting but that a skip was not a pause – as a “pause says you may hold there for a while, and I don’t know if we are ready for that.”

Lastly, being month-end, Bloomberg projects the duration extension of the 1-30y TIPS indices to be 0.02y for Series-B and 0.03y for Series-L.

Heading into the sunset of today’s trade, the 2y breakeven is going out at 205.625bps (-5.625bps), 5y at 210.5bps (-4.875bps), 10y at 218.25bps (-4.75bps) and 30y at 223.625bps (-5.625bps).

Deutsche Bank: Long-run market inflation expectations losing faith

Since the oil price collapse in 2014, strategists at Deutsche Bank have highlighted the surprisingly high correlation between spot oil prices and long-term market-based measures of inflation expectations.  Over this time, the bank has found that “Brent oil prices have been about 75-80% contemporaneously correlated with 5y5y breakevens and inflation swaps, a much higher co-movement than prevailed prior to the oil shock. This newly formed relationship has served as one fundamental – albeit simplistic – gauge of where 5y5y breakevens and inflation swaps should be. 

That said, Deutsche Bank also finds that “material divergences between the relationship in the past five years have coincided with clear drivers, like the rise in inflation expectations relative to oil following the 2016 election as the Trump reflation trade took hold,” and it expounds on the relationship below and its implications for the Fed:

”…Prior to and during the early parts of the pandemic, measures of long-run inflation  expectations were generally below levels implied by oil prices. That relationship  flipped with the results of the 2020 elections which ushered in a period of substantial fiscal stimulus. Following that temporary rise, however, long-run inflation expectations were consistently below levels implied by oil prices, even as actual inflation continued to print at elevated levels throughout 2021 and 2022. Over this period, the Fed appeared to have substantial credibility with the market that they were committed to do what it takes to get inflation back to target over time. No doubt the historically aggressive tightening cycle, including four consecutive 75bps rate increases, played a critical role in earning this support.

 

“…More recently, however, market measures of long-run inflation expectations have hit new highs, even as oil prices have remained subdued. Just last week, 5y5y breakevens and inflation swaps both reached the highest levels since last October / November, even though Brent oil prices are about $20 / barrel below the levels that prevailed at that time.

 

“…The residuals from a simple linear regression model of long-run inflation expectations on oil prices demonstrates the extent of the current disconnect. Over the past week, 5y5y breakeven and inflation swap residuals relative to oil hit high levels of 17bp and 24bps, respectively. The former is the highest since August 2021, while the latter is the highest in six years.

 

“…In the past, we have found that measures of nominal term premia have often been able to explain the residual of long-term inflation expectations versus oil. When that is the case, we interpreted the movements in market measures of inflation compensation as reflecting changes in risk premia rather than a pure read on inflation expectations. However, this close co-movement has not been present recently. 10-year term premia have remained relatively subdued even as the residuals between inflation compensation and oil have spiked to higher levels. We interpret these developments as signaling a true rise in inflation expectations.

 

“…Time will tell if this new relationship between oil and long-run measures of market inflation compensation is sustained. If it is, it will be a worrying development for the Fed, which has undertaken an aggressive tightening campaign to maintain inflation fighting credibility but had since been positioning to at least skip a rate hike at the June meeting. Along with other key data releases, the movements in inflation expectations raise questions about whether such a decision would be prudent.”

Inflation-linked structures - UBS

• UBS is working on a self-led $8.445m inflation-linked note maturing Jun 2024 that pays 7.7*(Eurozone CPI NSA-1), floored at zero. Eurodollar.