better late than never (2022 rates playbook) and global / biz CYCLE update(s)
a large French bank and an 'ole (1st)Boston shop and a Reid on things...
In case these get ‘buried by the lead’ or fall to cutting room floor in editing process for the weekend sellside observations, a couple items to consider.
First is a 2022 rates playbook by a large French bank detailing,
US rates are dynamically repricing the interaction of monetary and fiscal forces, as the huge and synchronized pandemic-related stimulus unwinds in 2022.
Under a fast Fed regime shift and BERT framework, we (still) expect a shift to a higher real rate environment (oscillating between ‘E’xpansion and ‘T’antrum).
Fed rate hikes and quantitative tightening (QT) could imply a 2018 rates playbook where 10y rates rose, 2s10s flattened, real yields rose sharply, breakevens tightened, 5-10y outperformed wings and mortgage basis widened.
2y UST yields are forecast to reach 1.75% at end-2022 with increasing velocity of policy exit as the Fed is expected to hike four times this year and engage in QT in H2. We target 2% on 10y rates with strong ALM demand and a collapsing fiscal deficit to partially offset a rise in fed funds rate and impact of Fed QT.
Shift to lower liquidity to accelerate from H2 with Fed QT, but the $1.6trn RRP buffer and limited collateral growth should limit the risk of reserves scarcity.
Vol tends to fall during hiking cycles, but given high and uncertain inflation, we begin the year cautious and look to sell spikes from current levels
Trades for consideration: Buy 5y in 2s5s10s UST butterfly, 5y30y vs 1y30y swaption calendar spread, buy 2y10y atmf +50bp vs atmf +150bp payer spread.
Jumping ahead TO the conclusion and trades for our collective consideration,
… 2s5s10s UST butterfly (long 5y, -1x2x-1): Entry = 34.5bp. Target = 0bp. Stop = 45bp. Carry = -1.5bp/month….
Our US rates model finds the belly of the curve (5y) cheap vs. the wings (especially 2y and 30y rates).
We find the 2s5s10s UST butterfly tends to rise just before and then fall during hiking cycles (see Playbook dashboard, slide 4 and rates model, slide 7). Owning the 5y UST on the butterfly also performed well during the last QT period in 2018. Mechanically, this makes sense as the 5y sector prices the hiking cycle in advance and then the 2y sector realizes the cycle by rising quickest on delivered rate hikes.
Historically, we find that entering the 2s5s10s about six weeks before lift-off and exiting three months later saw a 35bp drop around lift-off in 2004 and a 30bp drop in 2015. Around ‘re-lift-off’ in 2016, 2s5s10s fell 10bp over a similar timeframe.
The 2s5s10s UST butterfly generally falls throughout the hiking cycle but the decline tends to be steepest just after lift-off (Figure 42). The timing of the trade is important as it increasingly carries negatively. Currently, 2s5s10s carry is -1.5bp for 1m, -6bp for 3m, and -16bp for 6m.
We expect the Fed to lift-off at the March FOMC and hike four times in 2022. However, we expect all seven meetings beginning in March to be live and do not rule out the Fed acting more aggressively. A quicker pace to the hiking cycle upon lift-off should benefit the trade, while delayed hikes (in conjunction with negative carry) is a risk to the trade.
Moving on to economic cycles and none better on global cycles than 1stBoston, who just wrote,
Global industrial production is at a high peak. Annualized growth stands at 8% in January. Part of the strength is due to modest easing in supply chain stresses: auto production has surged as semiconductors became more available. Asian industrial production has recovered from various disruptions.
Accelerations in industrial production are often associated with rising bond yields, and vice versa. The recent rise in momentum has been no exception.
Industrial production momentum will inevitably fall in the next few months. Annualized growth of 8% is well above the long-term average and unlikely to be sustained. We expect momentum to trough at around 2% in Q2, before resuming a pace modestly above its 3% long-term trend.
There are risks the slowdown is deeper. The Omicron wave is just starting in Asia. A temporary pause or reversal in easing supply pressures seems likely, but the magnitude is uncertain. Consumer demand is slowing and vulnerable to near-term risks.
After these issues have cleared, fundamentals are supportive of brisk industrial production growth as output catches back up with demand, order backlogs are filled and inventories replenished.
In addition TO 1stBOS thoughts on the cycle, how about the latest CoTD from large German bank looking at cycles and noting,
Yesterday I published my monthly chartbook called “The road to the next recession” (link here). With inflation rampant, the US employment and output gaps as good as closed, the Fed playing catch-up, and the yield curve flattening, it’s fair to say that the classic ingredients for the next recession are falling into place. However the chartbook suggests those waiting for the cycle to roll over imminently will likely have to be patient.
Our guesstimate in the pack for when the next recession might start was mid-2024. If true this expansion would be only just over 4 years. This feels very short but today’s CoTD shows that this would still be the 8th longest US cycle out of the 35 over the last 170 years.
All four of the previous cycles (since 1982) have been in the top six longest of all time so what’s to stop this current cycle lasting as long? A few things in my opinion: First, the output and employment gaps have closed much earlier in this cycle than the other four (p.17); second, interest rate rises (likely) and yield curve flattening (p.3) are generally happening much earlier; and third inflation is accelerating at a pace not seen at this stage in these previous cycles. The third point is probably the swing factor. Over the 1982-2020 period and four very long cycles, inflation was largely controlled by exogenous disinflationary forces. As such whenever the economy looked likely to roll over, the authorities had carte blanche to loosen policy to extend the cycle. It doesn’t look likely they’ll be so fortunate this time and will have to choose between tackling inflation or reducing economic risks.
Interestingly though, the third longest cycle in history occurred in the mid-to-late 1960s when the Fed responded to equity market weakness by cutting rates rather than continuing to raise them in what was an inflationary environment. This extended the cycle but arguably locked in higher inflation before we even got to the inflationary 1970s. CPI ended the 1960s at 6.2% (yoy) and had already forced a hawkish Fed pivot. They arguably had to hike more aggressively than they might have needed to a few years earlier and this led to the delayed onset of the recession.
So there is no certainty to when the next recession will start, just analytical guess work. The Fed could still ensure another long cycle if inflation pressures collapse or if they decide to prioritise the cycle/financial conditions. However, at this stage their job looks tougher than during the 1982-2020 long cycle period.
Will revisit all at some point and you might, too .. perhaps AFTER FOMC dust settles tomorrow …