If last week marked the “throwing in the towel” moment for Deutsche Bank’s Dominic Konstam with regard to the prospect of higher long-end rates, this week looks to mark a complete rethink of his team’s thesis (at least in the near-term).
Yes, Konstam’s latest note (out a day early this week to account for the holiday) still contains plenty of speculation as to how we could still get a steeper curve, there’s a decidedly conciliatory tone with regard to the prospect of bull flattening.
As for the former outcome (a steeper curve) Konstam notes that risk-off scenario could well see the market re-price expectations for the pace of FF hikes, which would concurrently squeeze the mammoth eurodollar short, but at the end of the day, the message is pretty clear. To wit:
A disruptive outcome in France could also produce two phases of curve adjustment, as Fed re-pricing (probably quickly) segues into a deeper risk off trade whereby risk assets roll over and breakevens decline, producing a sharp bullish flattener.
That’s about as clear as one could make it.
Below, find the details.
Via Deutsche Bank
We see the balance of risks as tilted toward still lower yields across the curve in the near term. Last week we revised our forecasts to reflect a near term dip in 10y yields toward 2%, with yields ending the current quarter at 2.25% and climbing to 2.75% by the end of 2017. This path reflects concern for risk off conditions driven by the French electoral process, significant delays or even failure of progrowth tax reform in the US, a possible slowdown in “soft” indicators such as our excess liquidity metric, and positioning. However, there remains a plausible path to higher rates. If the French electoral process is not acutely disruptive, if progress is eventually made on tax reform, and if the data remain resilient then rates should rise again and the Fed could push on. In this sort of scenario the Fed’s trade-off between balance sheet reduction and rate hikes would likely come into greater focus.
Our prior is that the near-term risk-off rally should at first produce bullish steepening of the curve as markets re-price to reflect some combination of a lower terminal rate and/or a slower speed of Fed hikes. Positioning could also steepen the curve as speculative investors remain heavily net short the Eurodollar complex and to a lesser degree FV contracts. A disruptive outcome in France could also produce two phases of curve adjustment, as Fed re-pricing (probably quickly) segues into a deeper risk off trade whereby risk assets roll over and breakevens decline, producing a sharp bullish flattener.
Looking past the French elections momentarily, we think that likely combinations of Fed balance sheet reduction and rate hikes also create the potential for significant curve re-shaping. Less aggressive hikes and a more rapid pace of SOMA portfolio rundown would augur for a steeper curve over time, while more aggressive hikes and a slower pace of balance sheet reduction would bias the curve flatter.
We see a significant market opportunity in the recent delivered correlations between changes in key rates on the yield curve. For example, the 30 day trailing correlation of changes in the 5y swap rate and 30y swap rate is 92%, which is the 85th percentile of the 5y distribution. Similarly, the correlation of changes in 5y rates and 10y rates is 97% (84th percentile), and the correlation of changes in 2y rates and 10y rates is 94% (98th percentile). If these elevated correlations look familiar, they should: correlations also rose significantly during the run-up to the Brexit vote and the US presidential election. The market opportunity lies in the fact that when correlations are high across the curve, curve volatility is low. This suggests that the recent run-up in delivered curve correlations is an attractive opportunity to sell those correlations via contingent CMS caps and floors.