DEALERS DIG FOR CURVE STRATEGIES AMID COLLAPSING YIELDS

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July 20th, 2012

Despite an ongoing shortage of yield in the fixed income markets of core developed economies, many dealers recommend maintaining or even supplementing long positions in Bunds and Treasuries for an extended Q3 rally. Calls for the shape of the curve vary but expectations are that yields can yet fall meaningfully further this quarter

The Rates Strategy team at Barclays Research said Treasuries are no place to hide but on the curve the 5-year has merit. In this week’s Market Strategy Americas file, BarCap wrote, “With the risk of the Fed disappointing on the IOER cut, we recommend moving long positions further out the curve to the 5y point. Separately, foreign investors continue to accumulate Treasuries in the belly, where the Fed is offsetting net supply. Declining float suggests that another asset purchase program is likely to have a substantial effect.” BarCap strategists further believe the market has not responded appropriately to weakening U.S. economic fundamentals (e.g., three straight months of negative retail sales growth and the lowest Philadelphia Fed employment index since late 2009) or to implementation issues for the EFSF that have come to the forefront, especially for Italian and Spanish debt yields. They likewise expect the US 5- and 10-year notes to rally to 0.5% and 1.25% (respectively) over “the coming months”. BarCap also finds the US 5-year sector to be more attractive versus the overnight index swaps curve. “Another reason to move out the curve is that 2-2.5y sector has richened versus the OIS curve as well. We had argued that it had cheapened excessively following the extension of Twist, despite Fed holdings being marginal in that sector. The Treasury-OIS basis has tightened and the sector does not look as attractive from a roll/carry perspective. While repo rates have also declined versus the fed funds rate, supporting the richening of Treasuries, dealer inventories are still elevated. A reversal of the repo rate is likely to hurt 2s more and the 5y sector looks more attractive from a levels perspective.”

Citigroup Global Markets noted the further divergence between the Citi Growth Index and 10-year note yields as markets ignore fundamentals. In their US Rates Chart Pack, Citi strategists wrote, “The Citi Growth Index has ticked higher recently on higher construction spending, industrial production and capital goods orders. Recent data has not been inspiring, but continues to be resilient.” Citi’s model puts fair value on US 2-year notes at 0.33%, about 11bp higher than the on-the-run security closed on July 19. For the 5-year note, fair value is 1.43%, some 82bp higher than the market currently allows. At a spread of 111bp, the 10s/30s curve is where it should be according to the model but the issues themselves yield far less than they should. Tens are about 135bp overvalued and 30s are about 136bp overvalued. The biggest spread between fair value and market yields is on the 5y5y forward model. Citi’s model suggests 4.30%, whereas the market closed Thursday at 2.53%, a rounded difference of 176bp. In Germany, Citi believes Bunds could reach new record lows in August. “We wouldn’t be surprised if 10yr Bund yield reach 1% over the summer.”

The rates and currencies team at Bank of America Merrill Lynch Global Research subtitled their latest weekly “Chasing Yield” and wrote, “The best explanation for the grind lower in rates, in our view, is the growing hunt for yield. We are looking for new lows in the US 10-year yield of 1.30% and we like expressing this long bias via receiver spreads. Specifically, we recommend buying receiver spreads on 10y rates either outright or by selling out-of-the-money payers. We recommend the 10-year as it should benefit from a risk-off event, and it has the best carry and roll down as well.” Seeing more performance potential in the long end as investors continue to extend out the curve, BoAML expects the 5-year to close the current quarter at 0.55%, while the 30-year would end Q3 at 2.40%. Note that BoAML’s anticipated 10s/30s curve nearly matches that in Citi Research’s macro valuation. Although BoAML revised their interest rate forecasts lower for Q3, they see rates rising after some event risks clear. We expect a small sell-off in rates in Q4-12 (10y at 1.75%) owing to some uncertainty being resolved after the presidential elections. While we expect nearly $300bn of fiscal tightening in 2013, the relief of certainty about the political spectrum is likely to result in a relief UST sell-off. This forecast depends heavily on how the cliff is handled. With some kicking-of-the-can, we see the curve steepening near year end and beyond, due to concerns with the debt ceiling and a US downgrade.”

From their latest US Interest Rate Strategy Weekly, Credit Suisse Research and Analytics believed that the test of resistance on 10yr US yields at 1.44/39% will hold at first. “However, we favor an eventual break lower to our core target at 1.13/11%. We continue to like buying on dips and still favor a 10s30s flattener in Treasuries. In derivatives this week we favor expressing a bullish bias by being long 5s versus 3s and 10s conditionally with one-year forward-starting receiver swaptions.”

Not all see US yields going lower from here. In a table of currency, commodity and interest rate forecasts published Friday, Goldman Sachs Global ECS Research indicated the US 10-year note yield would rise to 1.80% in three months, to 2.00% in six months and to 2.20% in 12 months. Over the next month, the spread to Germany’s 10-year Bund yield would be more or less steady from its present level near -30bp. Six months from now, however, the spread would narrow to -20bp and remain there when we look a year from now.

As volatility in 10-year UST yields moderates at record low levels, Deutsche Bank Securities suggested it’s time for corporate bond issuance to increase. In their Macro Strategy note for July 20, DB strategists wrote, “We haven’t seen a +/-5bp daily move in the 10-year for two weeks now. Given the ongoing inflows, market technicals remain supportive for corporate bonds as investors continue to chase spread products in a low volatility and low yield environment.”

While fresh dealer recommendations tend to concur on staying long in safe-haven assets, they differ somewhat on the optimal duration profile. Next week’s $99 bln supply of new 2-, 5- and 7-year Treasury notes carries the prospect of a short-term flatter curve amid the sequence of auction concessions, if they’re even needed. Should a larger data or credit event cause risk markets to totter, dealers see yields falling across the term structure regardless of how low they are already.

 

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