Rates 10y Dashboard: Should Curve Flattening Persist with Rising Rates Volatility?

Inflationary fears gripped the market again following the release yesterday of the June CPI data in the US. Although many components of the CPI basket that are deemed to be transitory displayed sharp increases, the rest of the components indicate rising inflationary pressures as well. Indeed, while the headline CPI reading of 5.4% YoY was the highest since 2008, the core CPI reading of 4.5% YoY was the highest since 1991.

The initial reaction to the data release was for the rates curve to flatten with the short end rising as it priced in the Fed raising rates earlier than previously implied by the curve. Later in the day, when the demand was weak for the 30-year US Treasury bond auction, the long-end sold off and the curve reversed course as it steepened.

US rates volatility thus increased following the data. The Move index is now back above 60 bp from a low of 50 bp a month ago. While still below the 10-year average and the peak of 75 bp earlier this year, the rise in US rates volatility does not bode well for EM rates volatility, as the chart below shows.

Data Source: Refinitiv; Note: EM = equally weighted index of rates in 19 countries

The rise in volatility raises the question of whether the flattening trend that had taken hold in the US and EM rates curve should persist. For context, see our note on the topic from a few weeks ago.

As the chart below shows, both US 2s5s and EM 2s5s have been strongly correlated as they have flattened by around 20 bp each from their respective peaks in March. In the long run, the curves should flatten with short ends moving higher and long ends lower as central banks get closer to exiting from highly accommodative stances. However, now that they are off the extremes, the shape of the curve is likely to be data-driven in the short term.

Data Source: Refinitiv; Note: EM = equally weighted index of rates in 19 countries

Indeed, different drivers could dominate in the short run depending on the specific data release, which could then define the direction of rates and the shape of the curve. To mention a few examples:

• If forthcoming inflation data continue to cast doubt on the Fed’s “transitory” thesis, as was the case yesterday, then the short end can move higher by pricing earlier rate hikes or the long end can move higher by pricing in the Fed being behind the curve or a combination of the two.
• Growth uncertainties still persist as is evident in China (see here), which is ahead in the economic cycle relative to other countries. As such, if activity data weakens in H2, then the short end may not move higher, but the long end may move lower.
• Budget deficits have globally ballooned since the start of the pandemic. As such, the supply of bonds generally is higher than in recent years and weak auctions like the one in the US yesterday should not be uncommon.

As a result, while we had made several flattening recommendations, including in Mexico, Chile, and South Africa, earlier this year, the trend ahead is less clear-cut. Therefore, given the near-term uncertainty, the dominant focus should be on the macro versus policymaking dynamics in individual countries – for example, which country is ahead of the curve in hiking rates, and which is behind – in deciding on trades.

Indeed, we currently have idiosyncratic trade recommendations in the form of a flattener in Colombia and a steepener in Russia. As the chart below shows, both are compelling at current levels. In addition, curve flatteners look appealing in India and Poland, two countries where the central banks are behind the curve in our view in terms of raising rates. On the other hand, a steepener in Brazil is beginning to look interesting.

Data Source: Refinitiv; Note: EM = equally weighted index of rates in 19 countries

Best Longs / Best Shorts

• From the list of underperformers based on our models in the attached Rates 10y Dashboard pdf, we removed Mexico 10y (MXN 10y) as its z-score receded, both on an outright basis and based on the spread to the US.
• The list now consists of Chile 10y (CLP 10y), Peru 10y (PEN 10y), and Colombia 10y (COP 10y).
• Meanwhile, the list of outperformers stayed empty.

Best Crosses

• The list of preferred relative-value trades based on our models changed to Receive PEN 10y vs Pay Russia 10y (RUB 10y) or Thailand 10y (THB 10y) or China 10y (CNY 10y) or Israel 10y (ILS 10y).
• The 3m expected returns for these pairs are in the range of 10.0-11.5% (not annualized), assuming mean reversion.