Market Economics | Interest Rate Strategy - BNP PARIBAS ...

steep curve is typically associated with low front-end
rates and more pronounced convexity along the yield
curve.
There seem to be two main periods that the model
fails to capture – in 1999, the hump traded 20-30bp
cheaper than implied and currently the hump is
trading 20-30bp richer than implied. One glaring
factor that was at play in both these periods is longend
Tsy supply, first declining in 1999 and now on
the rise in 2010.
Looking at the model residual (Chart 5), the
excessive richness/cheapness in the hump has
historically tracked the year-on-year change in
10y+30y supply. The chart suggests that there could
be a further 10-20bp richening to go before
eventually seeing a reversal, although this is only a
rough long-term guide.
Even then, using quantifiable inputs we find there is
not enough evidence yet for playing for a cheapening
in the hump. Our economists’ base-case scenario for
the Fed to remain on hold for around a year suggests
that the money-market slope should be kept from
rising in the near future, and the Fed keeping
monetary conditions loose should continue to support
liquidity and keep the VIX low. As implied by the
model, these factors would lead to the hump of the
curve staying relatively rich.
Another reason often cited to explain the hump’s
richness is that, as balance-sheet room has been a
concern during the crisis, this has led to some of the
demand for Tsys shifting toward swaps and futures.
There is already anecdotal evidence of liability
managers and other hedgers using futures more
actively. If this were to be at the expense of Tsys,
then it could mean that demand has shifted from the
benchmark points (10y and 30y) to the hump of the
curve, which the US and WN contracts are linked to.
We can try and isolate the activity of hedgers by
looking at only commercial positions, and there is
indeed heightened hedging activity in TY+US (see
Chart 6, no breakdown available on WN contracts
yet).
The risk to our view is that the economic recovery is
quicker than expected, with increased rate hike
expectations pointing to a cheapening of the hump.
In this scenario, the deficit outlook could improve and
10y+30y Tsy supply would thus be expected to fall,
also leading to a relative cheapening in the hump.
These would be gradual factors that we can look out
for. The only sudden cheapening we can envision is
if there were even more heightened credit risks from
the Greece situation, leading to a higher VIX. Barring
this, the main takeaway is that even though the hump
of the curve is trading historically rich vs 10s and
Chart 6: Net Commercial Longs in TY+US
800,000
600,000
400,000
200,000
0
-200,000
-400,000
-600,000
Jun-07 Dec-07 Jul-08 Feb-09 Sep-09 Apr-10
Source: BNP Paribas
60%
40%
20%
0%
Chart 7: Pace of Change in Treasuries
Outstanding, and 10y Swap Spread
YoY Change in 1+ Yrs
-20%
Debt Outstanding
130
Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11
Source: BNP Paribas
Forecast
10y Swap Spread (RHS, Inv.)
30s, we would rather play for a continuation right now
rather than fade it.
Overall effect of supply on outright swap spreads
We have written about this since the start of the year,
with the main point being that empirical evidence
supports the intuition that greater supply means
tighter swap spreads.
In Chart 7, we show that the best way to use
issuance data to explain 10y spreads historically is
by using the y/y % changes in Tsys outstanding,
rather than the dollar changes or the cumulative
amount of Tsys outstanding. Since the pace of
increases is now expected to back away from the
extreme levels of last year, issuance is unlikely to
add to further tightening and in fact may exert less
pressure. While there are several other structural
factors at play (balance sheet room, low vol/credit
spread environment, lack of convexity paying), the
issuance factor alone should reduce the chance of
seeing 10y spreads make new lows.
-30
10
50
90
Suvrat Prakash 7 May 2010
Market Mover, Non-Objective Research Section
35
www.GlobalMarkets.bnpparibas.com