RESEARCH ROUNDUP: UST Curve Flattening Is a New ‘Conundrum’
(Bloomberg) -- Positioning views on U.S. rates grapple with drivers of yield curve flattening and scope for flattening to continue or reverse; key factors include growth and inflation expectations, and how market responds to Fed balance sheet normalization.
- Deutsche Bank (strategists led by Stuart Sparks)
- Recent curve flattening hearkens back to “‘conundrum’ experience” during tightening cycle of 2000s; however, foreign inflows “are far lighter” this time, and QE flows “do not square the circle”
- While curve “looks too flat,” lowering the long-term trend growth rate -- consistent with “chronically low productivity growth” and demographic trends -- “forces the model’s error to zero”
- Low productivity growth means that Fed’s stance “could already be tighter than intended,” increasing the probability of 2s5s flattening
- Nomura (strategists led by George Goncalves)
- Declines in long-term rates while Fed is hiking are “rekindling the idea we’re in another conundrum”
- These declines are being driven by fund flows “reacting as if CBs will never turn hawkish and truly tighten again”
- Nomura believes “we are entering a period in which investors can fade the CB-driven conundrum,” which “may begin with a hawkish Fed hike and hints that portfolio unwinds are closer”
- “We see risks of bear steepeners soon”
- Morgan Stanley (strategists led by Matthew Hornbach)
- Yield curve is likely to be flatter than market-implied forwards over next 12 months, but steeper than forwards over next 3 months
- “The further the Fed ventures into its tightening cycle, the more we expect investors to price in the next easing cycle, especially as core inflation in the U.S. remains subdued”
- Curve should invert from fed funds to 2s, reaching -0.225% by the June 2018 FOMC meeting
- Assuming fed funds range of 1.75%-2% at that point, investors “will think the Fed is done hiking, or very close to it, and will be thinking about rate cuts on the horizon”
- Two factors will drive rate-cut expectations: balance-sheet normalization, which “may necessitate a more aggressive rate-cutting cycle,” and lackluster inflation
- Trade recommendation: EDZ7/EDZ9 flattener at 53.5bp
- Citi (Ruslan Bikbov and Jason Williams)
- Carry-efficient flatteners (2s5s and 2s10s) are recommended based on Fed view, supply-demand and positioning; express in eurodollar futures, where shorts are stretched, or in swaps
- FOMC “continues to stick to the temporary disinflation thesis,” supporting the 2y rate
- Prospect of increased demand from China also supports 2s5s flattener; balance-sheet normalization poses risk, but “is largely priced in”
- Leveraged funds “remain extremely short” eurodollar futures, probably concentrated in late reds/early greens, and Libor-OIS basis tightening “is likely causing unexpected pain”
- JPMorgan (strategists led by Jay Barry)
- Risks “are biased toward lower yields into the summer” because of seasonals around the FOMC meeting and the possibility that the debt ceiling will “become a front-order event”
- Into FOMC meeting, JPM remains tactically bearish -- maintains short 3s and 10s30s flatteners -- because yields “have more than fully adjusted for weaker-than-expected data” and this week’s auctions will require concession to underwrite because of the meeting
- Barclays (strategists led by Rajiv Setia)
- Maintains recommendation to be short UST 2Y “as the market’s path of hiking cycle appears too benign”
To contact the reporter on this story: Elizabeth Stanton in New York at estanton@bloomberg.net To contact the editors responsible for this story: Boris Korby at bkorby1@bloomberg.net Greg Chang, Elizabeth Stanton
Alert:
HALISTER1Source: BFW (Bloomberg First Word)
People Stuart Sparks (Deutsche Bank AG)
George Goncalves (Nomura Holdings Inc)
Jason Williams (Citigroup Inc)
Jay Barry (JPMorgan Chase & Co)
Matthew Hornbach (Morgan Stanley & Co LLC)
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