From Barclays Insight :
UNITED STATES: RATES STRATEGY
Too much, too soon
Global bond yields have rallied from the recent highs as investors continue to reassess political risk in the US and euro area. Fed Chair Yellen is scheduled to testify next week; markets have pared back expectations of the hiking cycle despite hawkish Fedspeak. Meanwhile, uncertainty related to the scope, composition, and timing of the tax reform remains elevated. We maintain our long 10y UST recommendation.
US Treasuries continued to rally over the week as investors pared back their expectations of the reflationary impact of new policies. 10y yields have declined 15bp from the recent highs, with breakevens contributing 10bp. In the euro area, investors continue to reassess the changing landscape of the French elections. Figure 2 shows that open interest in French government bond futures has risen sharply. This has been accompanied by a decline in the election market implied probability of Francois Fillon winning the election and a widening of French-German government bond spreads (Figure 3 and 4).
In the US, economic data have largely been in line with expectations, although Fedspeak has been somewhat hawkish. Philadelphia Fed President Harker noted that a March hike is on the table, pointing to the good jobs numbers in the latest report. Chicago Fed President Evans, who is one of the dovish members, noted that “the way things are going, I could see three hikes. I could be comfortable with that.” Similarly, San Fran Fed President Williams, not a voter in 2017, has said that “There’s some optionality to moving sooner rather than waiting this year…We can slow down if the economy doesn’t do as much, but if we get these upside risks we’re well-positioned to increase more.”
Fed Chair Yellen is scheduled to deliver the semi-annual testimony on February 14 and we would look to her speech for her latest views on the labor market front and the outlook for hikes in 2017. In her latest speech, she noted that “Both the labor force participation rate and the employment-to-population ratio are still much lower than they were a decade ago. But the cyclical element in these declines looks to have largely disappeared, and what is left seems to mostly reflect the aging of the population and other secular trends”. Were she to reiterate that view, particularly in the light of the latest uptick in LFPR, we believe that would suggest that the Fed has not materially changed the policy outlook since the December meeting. With the market having pared back the number of expected hikes both in 2017 and 2018 (Figure 5), we believe there is room for a hawkish surprise, which should bias the yield curve flatter.
Meanwhile on the political front, in a recent interview with PBS1, House speaker Paul Ryan discussed the plans on tax reform. He noted that “we’re planning revenue-neutral tax reform, which means you have to take away loopholes and special interest deductions if you’re going to lower tax rates. That’s clearly what we’re working on doing. It does affect both what we call the individual side of the tax code and the business side of the tax code. And we propose it on a revenue-neutral basis. And we also propose permanent tax reform.”
Ryan seems to be differentiating between personal and corporate tax reform, noting that “When we did the 2001 and 2003 tax cuts in the Bush administration, those were only individual tax cuts, which you can actually make those temporary. You can’t do that on the business side of the code. It actually doesn’t work. It produces a lot of uncertainty for businesses. You can’t completely redesign the budget tax system for nine-and-a-half years, and then flip it back in 10 years. It doesn’t work like that. So, it has to be permanent”
The Tax Policy Center (TPC) has estimated2 that the GOP tax plan would lower revenues by $3.1trn over the next decade on a static basis (of which $2trn would come from the personal tax reform) and $2.5trn after accounting for the macro feedback. In other words, it is not estimated to be revenue neutral over the next decade by the TPC. Further, the border adjustment tax, which has become contentious, appears to be integral to the corporate tax reform as it raises revenues of about $1.2trn.
Hence, while the base case remains for a tax reform in 2017, one possibility is that if the corporate tax reform proves to be too contentious to resolve in the coming months, the Congress simply goes ahead with personal tax cuts, making them temporary to ensure revenue neutrality, while continuing to work on the corporate tax reform. While such an outcome would be positive for US consumers, providing a short-term boost to growth, it is likely to be seen as negative for risk assets as the probability of a corporate tax reform eventually occurring would decline. Our equity strategists estimate that lowering the tax rate to 20% would provide a 12% boost to S&P500 EPS. Figure 6 shows that the correlation between stock and bond returns is negative, suggesting that were the stock market to correct, US Treasuries are likely to rally.
In terms of trades, we maintain our recommendation to be long 10y US Treasuries (initiated at 2.52%) as we continue to see room for expectations around the effect of new policies to become more realistic. We also maintain our 3s10s curve flattener. As discussed above, we believe there is scope for the Fed to be perceived as hawkish, which should flatten the curve. Further positioning remains short, in our view (Figure 7).
US front-end spreads may be topping out
2y swap spreads in the US have widened considerably over the past year, from 5bp in Feb 2016 to nearly 31bp currently. Two main factors drove the move in front-end spreads over the past year. Until September 2016, the widening was mostly driven by 2y Libor-OIS spreads widening as the market came to price in the effect of outflows from prime money funds. In the subsequent period, the widening has mostly been driven by 2y Treasuries richening to OIS, mainly because repo rates declined relative to fed funds.
The market is now pricing GCF repo rates to trade 6bp cheap to effective fed funds a few months from now and our money market strategists expect repo rates to cheapen further relative to fed funds rates as T-bill supply increases in H2 17 (Figure 8). Unless Libor-OIS spreads were to be substantially wider, it would be difficult for 2y spreads to widen further if the market comes to price in such a rise in future repo rates relative to fed funds. As a result, the widening trend in 2y swap spreads may now be coming to an end.
• US Treasuries continued to rally over the week as investors pared back their expectations of the reflationary impact of new policies.
• We maintain our recommendation of going tactically long 10y US Treasuries (at 2.52%), as, in our view, the markets are too complacent despite elevated policy uncertainty.
• We maintain our recommendation to be in 3s10s Treasury curve-flatteners, as the Fed Chair’s testimony could be perceived as hawkish and term premia have room to decline.
• The widening in 2y spreads is likely to come to an end, given that repo rate futures are no longer pricing as much richness relative to fed funds as they were in January.
• The moves higher in equities and rates over the past month are likely to act as a paying overhang in the long end from VA hedgers. In the longer term, increased fiscal deficits/Treasury supply could tighten long-end spreads.
• We continue to recommend buying a 3m*30y ATM-25bp receiver funded by selling an ATM+25b payer as a way to benefit from cheap receiver skew, given our view that long-end rates are unlikely to sell off sharply.
• We continue to recommend buying a 2y*2y atm-100 low strike receiver as a tail risk hedge for a potential economic downturn in the medium term.
• We recommend selling TYM7 122 puts and buying matched high strike payers to benefit from any potential spread widening in a large selloff.
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