Download UST Curve: Belly`s too big

UST Curve: Belly’s too big
15 January 2016
Interest rate strategy
UST Curve: Belly’s too big
DBS Group Research
15 January 2016
• The outperformance in 5Y USTs looks overdone relative to the 2Y
and 10Y tenors. The belly is too fat
• 5Y USTs are likely to underperform when risk aversion recedes
• A reversal in Fed policy is the key risk to this outlook
US Treasuries (USTs) are major beneficiaries of the risk aversion that has prevailed since the beginning of the year. From the crash in Chinese equities to
worries on CNY depreciation, the market also has to contend with a rout in US
equities and WTI prices hovering around USD 30/bbl. Treasuries are reflecting
flight to safety and sharply lower inflation expectations over the medium term.
In terms of the curve, the belly has outperformed the wings with the 2Y/5Y/10Y
butterfly spread compressing close to zero.
We reckon 5Y UST yields are too low relative to 2Y and 10Y yields and see
scope for the butterfly spread to widen when risk aversion eases. Looking at
historical performance, the 2Y/5Y/10Y butterfly spread is unlikely to dip into
negative territory as long as the Fed is biased towards higher policy rates. Over
the past 15 years, there have been two notable periods where the spread was
negative. The first was when the rate hike cycle was well underway in 2005/06;
the second was when quantitative easing and dovish forward guidance distorted the UST curve from 2010-2012.
If Fed normalization proceeds, the market is likely to refocus on the pace of
rate hikes in the coming weeks. In particular, 3Y-5Y rates appear to be the most
vulnerable to any shift in Fed expectations. As a point of reference, the implied
Fed funds rate for end-2017 now stands at 1.06% (down from 1.45% at the end
2Y/5Y/10Y Butterfly
bps
Period of QE
and dovish
forward
guidance
100
80
60
40
20
0
-20
-40
-60
-80
Well into Fed
tightening cycle
-100
Jan-00
Jan-05
Jan-10
Jan-15
Eugene Leow • (65) 6878-2842 • [email protected]
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UST Curve: Belly’s too big
15 January 2016
Fed Funds Rate: Implied & Fed Projections
WTI crude prices & inflation expectations
% pa
USD/bbl
3.5
65
3.0
2.5
WTI crude (lhs)
60
Median Fed
projections
(Dec-15),
interpolated
2.40
55
2.30
50
2.0
2.20
45
1.5
2.10
40
1.0
35
0.5
0.0
Jan-16
%
2.50
30
Implied Fed Funds rate
Jan-17
Jan-18
Jan-19
25
Jan-15
2.00
US 5Y inflation swap,
5Y forward (rhs)
1.90
1.80
Apr-15
Jul-15
Oct-15
Jan-16
of 2015), pointing to just 3 hikes over the next 2 years. Similarly, the implied
rate for end-2018 is now at 1.39%. This seems too dovish.
Meanwhile, 10Y UST yields need not head sharply higher with Fed normalizing
policy. Inflation expectations will play a bigger role. With oil prices continuing
to drift lower and wages showing no sign of acceleration, upward pressure on
longer-term yields are likely to prove modest. Taken together, these dynamics
would result in a steepening in the 2Y/5Y segment of the curve relative to the
5Y/10Y segment, widening the 2Y/5Y/10Y butterfly spread.
If volatility persists and concerns on the real economy intensify, UST yields are
likely to fall further. However, the belly of the curve is unlikely to continue outperforming. Notably, if Fed hikes get delayed (but not derailed), the front of
the curve is likely to benefit more as the market pushes back rate hike expectations, leading to more steepening in 2Y/5Y segment of the curve compared to
the back end. This scenario also points to a widening of the 2Y/5Y/10Y butterfly
spread but of a smaller magnitude.
A reversal of Fed policy is the key risk
The key risk to our view is a reversal in Fed policy. This would require very significant market volatility and a weakening of US’s economic data in the coming
months. If the Fed were forced to reverse course, the UST curve would resemble the period from 2010-2012 with the 2Y/5Y/10Y butterfly spread pushing
deep into negative territory.
Sources:
All data are sourced from CEIC Data and Bloomberg. Transformations and
forecasts are DBS Group Research.
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UST Curve: Belly’s too big
15 January 2016
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