USDi: BEs languish lower; Refunding ahead

Chart up line Oct 2022
Nominal yields rose and TIPS RY underperformed even more in the front and belly, leading BEs to narrow. Citi examines 3y2y forwards.

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  • BEs languish lower; Refunding ahead

  • 3y2y forward examined – Citigroup   

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    BEs languish lower; Refunding ahead

    Nominal yields rose 2.5 to 9 bps on the day in a bear steepening move today. TIPS real yields struggled in a choppy session and ultimately underperformed, sending breakevens lower by as much as 2.5bps, led by the belly. Meanwhile energy ended lower (WTI -0.11%, Brent -0.22% and NYH gasoline -0.45%) while equities closed mixed (DJIA +0.2%, S&P -0.27% and Nasdaq -0.43%). 


    In ZC swap activity, not much was reported, though some short end and switches did trade. For example, 1y ZC swaps traded at 238bps, a switch of 1y ZC swaps dealt at 238.5bps versus 2y ZC swaps at 246.625bps, 3y ZC swaps traded at 251bps, and 5y ZC swaps dealt at 262.5bps versus 6y ZC swaps 264.25bps, according to the SDR.  


    Ahead, tomorrow the Treasury announces its refunding and analysts at Barclays do not expect any changes in TIPS issuance. However, Barclays does anticipate that “modest increases starting next year to be announced at the November refunding.” Meanwhile analysts at Citigroup expect “TIPS auction sizes to increase starting in October.”


    Currently, the 2y breakeven is at 208.2bps (-1.6bps), 5y at 228.2bps (-2.5bps), 10y at 235.9bps (-1.3bps) and 30y at 229.6bps (+0.6bps).



    3y2y forward examined – Citigroup

    Analysts at Citigroup examine what it would take for 3y forward 2y inflation swap rate to move lower. “Historically, 3y2y inflation swap rate has rarely traded above 3%,” with for example, noting “3y2y peaked at 2.9% in 2022 even when realized yoy inflation reached as high as 9% (forward looking inflation expectations were anchored),” Citigroup points out.


    “At 2.77%, 3y2y inflation is currently trading high compared to both 1y and 1y1y inflation swap levels based on their historical relationship,” the bank says.


    Citigroup sees two probable reasons for this richness in 3y2y inflation swap rate: “i) Inflation markets are worried that the recent slowdown in inflation is a temporary phenomenon, and that over time inflation will start to move higher and/or ii) the extremely strong demand for 5y TIPS is pushing the 3y2y artificially higher as most of the inflation shorts are limited to the very front end of the curve.”


    “If markets are really worried about inflation picking up once again, it is reasonable to expect that the upcoming consistently low MoM inflation prints would gradually assuage those concerns,” Citigroup assesses. In its analysis, “if the fixing markets are correct, inflation is unlikely to move higher anytime soon and based on historical evidence, 3y2y will soon follow realized inflation lower,” it finds.


    Further, “if the higher 3y2y inflation is purely a consequence of extremely high demand for 5y TIPS (breakevens), we do not expect that to last for too long,” Citigroup notes.


    Citigroup finds that with the recent move higher in breakevens, “TIPS do not look as attractive as they did against nominals when 10y BEs were at 2.2%, so unless MoM inflation suddenly starts to materially surprise on the higher side, we expect 3y2y inflation to move lower over the next few months.” As a result, Citigroup favors continuing to hold its 3y2y-10y10y inflation swap steepener.