MARKET MOVER - BNP PARIBAS - Investment Services India

This section is classified as non-objective research
now, go with the bull-flattening move, overweighting
the 10y sector (vs 5s and the back end) since it tends
to outperform on an RV basis even as 10s30s may
flatten (5s10s flattens more, that’s all) – see Chart 1.
Furthermore, as the curve flattens in a rally, home in
on the sectors with the best rolldown, which, by the
way, is in the 4y to 5y area. As an aside, for those
who can use options, we recommend going long this
sector using options since the strong rolldown more
than offsets the decay, due to theta in structures,
such as the 4y1y ATMF receivers, etc. (See “Too
Steep, Too Fast? The Case of the 1y Forwards”, in
this week’s Market Mover for further details.)
Looking past month-end, our focus will be on a resteepening
of the curve, with rates ratcheted higher
as markets begin to feel the long-term impact of the
Fed’s actions, with risk appetite staying firm. There is
also a local steepening bias heading into the 3y, 10y
and 30y supply over Oct 9-11, but again this will be
secondary to the bigger forces in place, namely the
support of the Fed. We think that the 10y Treasury
can settle in a range from 1.80% to 2.10%, using for
guidance the lull that lasted from late-2011 through
early-2012 (see Chart 2). That was a period of
relative calm in Europe, while the US economy
appeared to show signs of resilience, both of which
proved to be too fleeting.
We do not foresee a runaway selloff beyond those
levels in the next few months, as the road ahead for
Europe will be choppy, even if the tail risk may no
longer be there. As rates rise, we expect the curve
dynamic we alluded to above to remain intact, only in
reverse, with the 10y underperforming on an RV
basis along the curve. As for 10s30s, note that this
sector of the curve steepened by 50bp from their
lows through each of the previous two rounds of QE.
To put things in perspective, so far 10s30s only
moved by about 20bp from their local lows we saw in
summer 2012, ahead of the Fed’s new QE program,
so it has room to go. Our favoured steepener position
remains 5s30s/7s30s though, as we expect the 5y to
just tread water in the 55 to 70bp area, keeping the
7y relatively anchored too.
TIPS
In TIPS, we continue to believe that there is
significant upside potential for breakevens, but we
have been sidelined now for a week, awaiting a
pullback from very rich levels in order to participate
again. We continue to emphasize that trading
breakevens from the short side constitutes too great
a risk for the potential reward, but we are happy to
stay neutral for the time being as breakevens sell off
in order to gain a better entry opportunity in the
future. For now, that means adding on dips in 10yr
breakevens back at 230bp and all the way back to
220bp, should that level arrive. The current level
around 2.50% seems justified, given the Fed’s QE,
but may need some correction in the short run.
Should the 10yr cheapen significantly further
following the auction, we would be buyers on dips.
We also believe that real money may be better
buyers, given the long-run implications of openended
QE and what we believe will be a much
greater flow into inflation products in the months
ahead. The persistent buying on dips that we have
seen convinces us that there is broader demand for
the 10yr.
Short-Term Financing
There are two headline topics in STIR right now: (1)
How fast and how far will Libor rates fall; and (2) Why
is repo still stubbornly high?
The stubborness of repo is actually serving as a soft
floor for 1m Libor rates, so we'll deal with that topic
first. As we said last week, the Fed's decision not to
halt the Treasury sellbacks in the short end has kept
primary dealer inventories of Treasury paper near
historical highs. Primary dealers borrow ~USD 500bn
of cash in the repo markets each day to finance their
books. The build-up of Treasury paper is keeping
upward pressure on Treasury GC repo rates, which
touched above 30bp late last week and are hovering
in the mid-20s now. Once again, this has made carry
on the 2y Treasury note flat to negative. It's a bit of a
head-scratcher as to why some investors prefer
lending cash unsecured at, for example, 15 bp in the
Fed funds market or 12bp for financial CP vs 25bp
collateralized by repo. It speaks not to the lack of
appetite for increasing yield, but to the lack of
fungibility and increased complexity of repo vs these
other markets. These constraints and the impending
quarter-end, no doubt, will keep repo elevated or
push it higher through the remainder of the month.
We do not expect repo to significantly decline
towards the single digits until the Fed ends their
sellbacks at year-end.
The repo effect will keep a soft floor under Libor
rates. The 3mL settings continue to fall by 0.3bp to
0.5bp per day, and are likely headed towards 25bp
by year-end. The slow decline in 1mL has ground to
a halt as – at ~22bp – it is roughly even to slightly
below overnight, secured financing. We do expect
more compression and lower rates in the front end of
the curve, and it is possible that Libor, CP, CDs and
other rates could fall well below repo ahead of yearend,
but we doubt it. Expect more compression in
3s1s and a flattening of the front Eurodollar curve
during the last quarter of 2012.
Agencies
There has been an extraordinary tightening of the
mortgage basis since the Fed confirmed that they will
Bülent Baygün / US Interest Rates Strategy Team 20 September 2012
Market Mover
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