Global rates trader

Ataper trade review

Yield response to FOMC minutes offers glimpse into potential reaction to taper talk. Range
bound UST spread outlook favors relative rather than outright spread expressions. TIPS supply
tailwind has been modest support to breakevens, should remain modest positive. Fed decision
on standing repo facility not imminent, with questions still unanswered. Banks increasingly
inclined to limit balance sheet size amid reserve growth. Direction of travel for European
spreads likely wider despite this week’s price action. OAT underperformance too early to reflect
election risk, but risks skewed to the upside while EU bonds likely effective hedge ahead of
2022 French election. UK traded inflation to trend down despite RPI surprise, sticky CPI-RPI
wedge argues for shorts in the forward space; go short 2y3y UK real yields. Dovish RBNZ tone
could translate to some moderation of hike pricing.

United States/North America

Minutes offer glimpse into potential market reaction to taper talk. US yields rose following
the release of the April FOMC minutes, which referenced a number of participants suggesting
that discussion of a plan to adjust the pace of asset purchases at “upcoming meetings” may be
appropriate if rapid progress toward the Committee’s goals continued. Our economists note that
the disappointing April employment report likely postpones the start of such discussions.
Nevertheless, the reaction offers some clues to how rates markets may view the taper
discussion. 10y real yields rose by about 4bp following the minutes, with a commensurate drop
in 10y breakevens. This ties in with our view that breakevens are more “fully priced” to our
economic outlook than real yields are, and hints of removal of accommodation could shift
relative pricing between the two components. That said, we acknowledged the possibility that
markets would require more inflation risk premium in a period of elevated inflation prints, and
had tightened the stops on our forward breakeven longs (which have since been triggered). In
terms of the real yield component, we noted recently that intermediate (and longer) horizon real
yield forwards have room to reprice higher, as markets do not yet appear to be requiring an
appropriate real risk premium. The absence of imminent catalysts, however, means that a
nominal rates short remains our preferred macro exposure for now. Another interesting element
of market moves following the minutes was that 5y real yields rose more than 10y real yields,
suggesting that the more significant pricing impact may be to liftoff and policy path pricing, and
less at longer maturity term premia.

Near term swap spread outlook still about belly relative value. While 2y UST-OIS spreads
remain firmly anchored just below zero, May has brought incremental tightening pressure to
spreads further out the curve, worth about 1.5bp to 5s and 10s and a somewhat more notable
5.5bp at the 30y point. Some of the shifts further out the curve reflect a combination of
weakness around the 30y refunding coupled with a shift in of Fed purchases towards the belly
of the curve (largely at the expense of the 20y sector, though 30s weakened in sympathy). From
a broader perspective, our outlook for the various drivers of swap spreads in our spread
framework suggests relatively range-bound spreads across the curve through the remainder of
the year. Long end spreads appear better priced for the supply outlook, though we could see
some further pressure near term, whereas the reverse is true at the front end—2s and 5s have
some support from the front end collateral squeeze, but this should reverse following debt limit
resolution, which could result in some tightening pressure here at that point. One potential
consideration that could affect spreads across the curve is if the Fed adjusts IOER without also
moving the RRP rate, it would likely result in cheaper financing costs versus OIS; while that
typically translates to wider spreads, given the IOER tweak would be small, we expect the net
impact on spreads to be modest. For now, our preferred spread expression remains one of
relative performance—we like belly spread longs (7y spreads) versus shorts in 2s and 20s given
carry considerations and shifts in Fed purchase allocations.

The TIPS supply tailwind. Despite the weak reception at this week’s 10y TIPS auction, the
broader TIPS supply backdrop has been a supportive one for the product. Treasury refrained
from upsizing TIPS auctions last year even as it massively raised nominal coupon auction sizes,
and has been only gradually adding to issuance this year. The net result has been a steady
decline in the TIPS share of Treasuries outstanding. Excluding what the Fed owns, TIPS now
account for just about 10% of Treasury coupons outstanding, down from about 11.5% a year
ago. Under our issuance and taper projections, that is likely to decline another percent over the
next year. Our empirical estimate suggests that the supply shift has been worth approximately
10bp of upside to breakevens across the curve, and the tightening of the inflation basis
(breakevens outperforming inflation swaps) similarly suggests the supply picture has been a
support (Exhibit 1). As we noted after the May refunding decision, it seems that there is support
for incrementally larger increases to TIPS auctions, but still within the context of fairly gradual
adjustments, suggesting to us that while the supply tailwind may be more modest from here, the
backdrop is likely to remain a relative positive for cash inflation.

Broad support at Fed for standing repo facilities. The April FOMC meeting minutes
contained an extended discussion on the pros and cons of establishing a (domestic) standing
repo facility, and making permanent the Foreign and International Monetary Authority (FIMA)
facility. On the former, the Fed staff noted that such a facility could help forestall “funding
strains that could spill over into other overnight markets and limit dealers’ intermediation
activity in financial markets,” but that it could also “be seen as a form of liquidity support for
nonbank financial institutions” that could incentivize them to take on more liquidity risk against
eligible securities than would otherwise be the case. While there appeared to be broad support
among FOMC members for such a facility, with a “substantial majority” seeing the benefits as
outweighing the costs, the Fed appears no closer to determining key design elements of such a
facility (ranging from pricing, counterparties, and accepted collateral). We had discussed many
of these considerations, and their implications for markets in a previous report, and concluded
that a standing fixed rate facility with not too broad access, and a rate set above the top of the
Fed’s target range, perhaps by about 25bp or more would be a good design compromise. While
such a facility would likely on the margin dampen repo volatility, it would primarily work to
enhance control of the fed funds rate, something several participants noted they would like to
see the facility’s design targeted towards. Given some of these outstanding questions, and the
absence of liquidity concerns (in fact, the current issue is excess liquidity pressuring front end
rates lower), we do not see any decision on this front as imminent. Our best guess is the Fed will
first make the FIMA (repo) facility permanent; it has fewer design variables that need to be
solved for, and there is a temporary version already up and running that is currently set to expire
September this year—that may be a reasonable time to make such a change.

SFO offers insights into bank reserve management. The roughly $700bn in reserve growth
so far this year on top of the ~$1.5tn increase last year is something we have long flagged
should increasingly put pressure on bank balance sheets. The March Senior Financial Officer
Survey offered some notable insights into how banks are managing their balance sheets as
reserves swell. Consistent with the prior survey, a large contingent of banks indicated less
willingness to grow their balance sheets. About a third of respondents noted their banks already
are taking action to limit the size of their balance sheets and intended to continue such actions,
and another third noted they would either preserve or shrink their size if they faced further
pressures. The subset of banks that intended to reduce the size of their balance sheets were also
queried on their preferred means of reducing liability growth. As shown in Exhibit 2, most
respondents clearly preferred some mix of allowing outstanding wholesale funding liabilities to
mature without replacement, reducing deposit rates on non-operational deposits, or simply
imposing client caps. A significant contingent of domestic banks that are FHLB members also
noted willingness to decrease FHLB advances as a way to mitigate balance sheet growth.

European Rates
Sovereign spreads now close to macro fair value. Sovereign spreads ended the week tighter,
reversing a gradual trend-widening since April. We’ve argued that this repricing higher and the
associated steepening of credit curves make sense, with the impulse of ECB balance sheet
support unlikely to be dovish from here and the tight starting point for spreads. The widening in
recent months leaves spreads closer, but still slightly tight, to our EMU spread valuation
framework, except in France which now trades slightly wide to our model estimates (Exhibit 3).
This suggests a more neutral valuation signal overall, and with a tactical pause in the broader
sell-off, possibly a bullish one for France. But as we argue below, the prospect of additional
election risk premium through 2H 2021 leads us to recommend underweight France vs Spain on
a six-month view, despite the (modest) valuation gap. The recent sell-off in core yields and net
widening in spreads makes risk-reward for the June meeting a little more balanced, but room for
spread compression remains limited amid a continued drift higher in core yields on an
improving European macro outlook and the likely modest reduction of the PEPP purchase pace
in June. We therefore still like being short 30y bunds, but tighten our stop to 37bp to reflect the
shifting risk-reward.
OATs have underperformed, but election risk will only build. With a little less than one year
remaining before the first round vote, French election risks are already in focus. Recent
underperformance of OATs would reflect a very early pricing of election risk relative to 2017,
and given the common correlation with broader sovereign spread markets (including other semi-
core markets) we think election risk is only a modest factor so far. We see risks of further
widening in OAT-bund spreads in late 2021/early 2022, with up to a 35bp parallel rise in the
OAT-bund credit curve. Given the increased carry costs at the 2y point following the recent
repricing in the front-end, we think the best volatility-adjusted shorts are in the belly of the
OAT-bund curve (around the 5y point). We have also previously highlighted the resilience of
EU bonds during periods of country-specific risk (Exhibit 4), something we expect to persist
given ongoing deepening of the EU bond market. Given roughly similar yield levels, short OAT
vs EU bonds is also likely to be an efficient election hedge.
Upside RPI surprise temporary, short 2y3y real yields: While UK CPI matched consensus at
1.5% y/y, the RPI-CPI wedge widened unexpectedly with RPI printing 50bp above expectations
at 2.9% y/y. This widening in part reflects methodological treatment of house prices, which may
prove sticky throughout 2021. As a result, we think shorting forward RPI inflation is a better
expression of our view of subdued inflationary pressures in coming years. We recommend
shifting our short 5y UK real yields recommendation to short 2y3y real yields (open -3.05%,
target -2.50%, stop -3.30%). We think the expression offers attractive risk/reward given the
current combination of: 1) elevated inflation, 2) early BoE liftoff (with 17bp priced by end-
2022) and 3) a flat forward curve with only 20bp priced each year end-2022 to end 2025. This
mix of pricing is hard to square—we think that lift-off is likely priced too early, but relative to
the current 2y pricing of OIS and inflation, 2y3y OIS rates should be higher.

Other G10 Markets

RBNZ meets under better backdrop. RBNZ officials will head into next week’s monetary
policy meeting under a backdrop of better-than-expected recent economic performance and an
improved near-term fiscal position. The bank’s updated path for the unemployment rate is likely
to be in focus. Our economists expect forecasts will be revised lower, but still show a near-term
“bump” in the path. If realized, we see the bank as likely to retain a dovish tone and maintain
current guidance, though we acknowledge risks that an updated path showing sustained declines
in the unemployment rate could see the RBNZ simultaneously pull forward its OCR track,
thereby delivering a hawkish signal to the market. At present, markets are fully discounting a
hike by September 2022, with an additional 3 hikes priced through end-2023, significantly
ahead of our economists’ own projection for liftoff in 1Q24. While it’s possible markets press
this further if the bank surprises on the hawkish side next week, we see risks skewed towards
markets fading the extent of normalization priced by then.