Pay 3Y-5Y as a cleaner bet
Eugene Leow23 Sep 2021
    Photo credit: Unsplash Photo

    The US Federal Reserve’s Open Market Committee gave the strongest hint, yet that taper is imminent. The FOMC statement indicated that “a moderation in pace of asset purchases may soon be warranted” with Fed Chair Powell suggesting that taper could be done around mid-2022. This has been largely communicated over the past few months and it is now generally accepted that the taper would likely be announced (and start) in November with an asset purchase reduction pace of about USD 15bn per month. 

    The quarterly economic projections had some notable revisions, many of which are line with our own numbers (see table above). GDP growth for 2021 was revised down to 5.9% (from 7%) while that of 2022 got lifted to 3.8% (from 3.3%). Conversely, core PCE inflation is now higher for 2021 and 2022, at 3.7% (from 3%)) and 2.3% (from 2.1%). The upshot is that the Fed is taking a more sanguine outlook, expecting slow growth and high inflation to both be transitory. That said, the dotplot is clearly more hawkish with members now evenly split for a 2022 liftoff. By end-2024, the median dotplot now shows a Fed funds rate of 1.75%.

    The US Treasuries curve flattened. The belly tenors (2Y to 5Y) came under pressure as the market starts to price in more rate hikes. However, longer-term yields fell with 10Y yields back at 1.30%. We had noted previously that a more hawkish Fed typically leads to flatter curves. These market moves echo what was seen post June’s FOMC meeting when the Fed first had the hawkish tilt. We note that the market is not convinced that the Fed would be able to deliver the amount of rate hikes shown in the dotplot. For example, implied Fed funds rate for end-2024 is at around 1.00%, 75bps lower than the dotplot projections. We think that this discount is likely due to the Fed’s asymmetrical reaction function to downside growth risks over the past two decades. Overall, still-low US yields reflect caution on the recovery and increasing worries about China’s growth.   

    Strategy wise, paying 3Y-5Y rates are a cleaner bet on Fed normalization. This Fed hike pricing discount should be reduced as taper proceeds and the market focus on rate hikes. 3Y and 5Y yields at 0.45% and 0.80% should be seen as pay opportunities. We are neutral on the 10Y tenor, with the 1.20-1.38% range still holding. We think a tactical pay at 1.25% makes sense. We still see fair value close to 1.6%. However, with lingering concerns on global growth (especially China), it may take awhile before longer-term rates grind higher. For Asia, we think that taper clarity would in time encourage carry plays. While USD did strengthen and there are still concerns on Evergrande, we note that EM / Asia govvies generally look undervalued and stick to our positive view for IndoGB. 

    Eugene Leow

    Senior Rates Strategist - G3 & Asia
    [email protected]

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