USD Swaps: Powell sticks to script; The rise of term premia

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Powell sticks to script; The rise of term premia

Fed Chair Powell largely stuck to script at his Jackson Hole speech today, repeating the well-worn refrain that US inflation remains too high and the Fed is at the ready to take further action if necessary.

“Although inflation has moved down from its peak – a welcome development – it remains too high,” Powell stated.  “We are prepared to raise rates further if appropriate, and intend to hold policy at restrictive levels until we are confident that inflation is moving sustainably toward our objective.”

In all, strategist at BNP Paribas took away the following key points from Powell’s speech:

• Fed Chair Powell delivered a nuanced keynote speech at Jackson Hole, maintaining a hawkish longer-run outlook and a more balanced nearer-term stance, in our view.

   

• We think the speech signaled no appetite to change the current 2% inflation target, nor for inflation to deviate from it for any extended period of time.

   

• In the nearer term, Powell seems largely content to hold rates steady at current levels, but remains data-dependent and liable to continue rate hikes if activity and labor market figures remain too strong.

   

• We continue to expect the Fed to hold fed funds at the current 5.5% upper bound through the rest of 2023 and into next year.

Looking at the trading screens, after an initial bout of volatility in rates during/after his speech, it looks like Powell’s comments have failed to cause much alarm as yields are now narrowly mixed (+/- 3bps) with the curve remaining flatter in the early afternoon trade.  The benchmark 10-year yield is last 0.2bps lower at 4.235% while the 2s10s spread is 3.1bps narrower at -81.9bps. 

Meanwhile, in SOFR-space, red SOFR futures are posting 3.5 to 7 tick losses while SOFR swap spreads are narrowly mixed with the wings outperforming amid decent activity overall.  In the backdrop, IG issuance is offline today despite a buoyant risk tone (Dow +0.59%, S&P +0.26%, Nasdaq +0.42%).  However, looking into September, syndicate sources look for roughly $120bn in IG issuance to price (…compared to the $78bn sold in September 2022).

More broadly, strategists at SocGen believe that “much of the Treasury sell-off since April can be attributed to a repricing higher of the Fed path as the long-expected recession failed to materialise.” Yet the bank finds that “for the past month, the front end has been relatively unchanged, while long-term yields have continued to rise.

SocGen attributes the rise in term premia to “an increase in the expected supply of duration, worries over foreign demand and uncertainty over the longer-run neutral rate.”   Additionally, the bank finds that “volatility has moved from the upper left to lower right corner, consistent with late-cycle rotation.

Over the short term, SocGen is “neutral on rates and the curve,” though over the longer term the ban expects “a bull steepening.”   SocGen expounds on its view below: 

”… The rise in Treasury yields from the beginning of April to a month ago coincided with a large repricing higher of the Fed path over the next two years in response to persistently hot US economic data. The expected terminal rate was raised from 4.5% to 5.5%, and rate cuts were pushed back into next year, i.e. higher for longer. For the past month, there has been little change in the expected Fed path over the next two years, yet the long end of the Treasury curve has continued to sell off. Increasing uncertainty about the long-run neutral rate, a large increase in the outlook for deficits and in the supply of duration, and vanishing foreign demand are all contributing to higher volatility at the long end and higher term premia. We believe data and sentiment on the strength of the US economy are unlikely to get much better from here, and thus the near-term Fed path is unlikely to rise much further. On the other hand, the debate over the long-run neutral rate and normalisation of term premia is unlikely to be resolved any time soon. We are more bullish on the front of the Treasury curve and lean towards steepening.”

SOFR swaps – 2s -12.75bps (+0.375bps), 3s -16.625bps (-0.25bps), 5s -22.375bps (-0.875bps), 7s -30.125bps (-0.75bps), 10s -27bps (-0.375bps), 20s -62.875bps (+0.25bps), 30s -65.5bps (+0.625bps).