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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] 1 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. 2 UST Curve: Belly’s too big 15 January 2016 Recent Research CN: services and manufacturing are codependent 14 Jan 16 IN: prepared, not immune 16 Dec 15 Qtrly: Economics-Markets-Strategy 1Q16 10 Dec 15 Holiday Heresies 2016 7 Dec 15 ID: manufacturing still a drag 3 Dec 15 CNH: billion dollar baby SG: when China devalues 20 Aug 15 TW: the impact of yuan devaluation 19 Aug 15 SG: saving manufacturing 17 Aug 15 IN: inflation remains key 6 Aug 15 IN Gilts: greater foreign ownership mooted 4 Aug 15 IDgov bonds: 2Y sector looks attractive 31 Jul 15 JP: Japan’s “go global” experience (2) 29 Jul 15 IN: harnessing demographic dividend 27 Jul 15 CN: fiscal reforms to accelerate (2) 24 Jul 15 16 Nov 15 EZ: will more QE help? 4 Nov 15 Rates: regional rates rundown 2 Nov 15 FX: monetary policy divergences intact 2 Nov 15 Rates: UST Curve - the next flattening leg 30 Oct 15 JP: deciphering the BOJ ID: no room to cut SG: slowest growth in six years 9 Jul 15 CN Rates: stock market woes driving onshore/offshore divergence 9 Jul 15 23 Oct 15 12 Oct 15 Greece: near the tipping point 6 Jul 15 IN: the lowdown in exports 9 Oct 15 ID: investors staying put 6 Jul 15 SG: technical recession 6 Oct 15 VN: Asia’s latest electronics spark 1 Jul 15 SGD: a lower policy band 6 Oct 15 Japan’s “go global” experience: implications for 30 Jun 15 China CN: resolving the known unknowns 5 Oct 15 G4: who’s winning the currency wars? 25 Sep 15 IN: RBI – another window opens 22 Sep 15 Japan’s “go global” experience (3) 21 Sep 15 SG: mandate for inclusive policy 17 Sep 15 Qtrly: Economics-Markets-Strategy 4Q15 10 Sep 15 Triangulating Asian Angst: the US, China and the 97 question 7 Sep 15 SG: watch core inflation 16 Jun 15 Qtrly: Economics-Markets-Strategy 3Q15 11 Jun 15 IN: weak monsoon a risk 8 Jun 15 CN: the AIIB to test diplomatic skills 4 Jun 15 Rates: the rise in global yields – where to now? 25 May 15 CN: the need for institutional reform 21 Aug 15 TH: still climbing Sisyphus’ Hill 22 May 15 IN: time to deliver 21 May 15 KR: what will the AIIB mean for Korea? 19 May 15 Disclaimer: The information herein is published by DBS Bank Ltd (the “Company”). 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