US swap rates: New volatility hierarchy taking hold - Natixis

According to René Defossez, Research Analyst at Natixis, in coming months, the Federal Reserve’s monetary tightening is set to gather pace compared with the past two years and as recalled by Fed Chair Janet Yellen last week, conditions are now present for the short rate to recover gradually towards its equilibrium level (i.e. 3%).

Key Quotes

“Were inflation to overshoot, i.e. rise significantly above the central bank target, not only would the Federal Reserve step up interest rate hikes, but it could temporarily increase the short rate above 3%.”

“One should therefore witness a new volatility hierarchy for US swap rates, at any rate a restoration of the pre-crisis hierarchy, when short rates explained to a large extent the movements along the yield curve.”

“To maintain the pre-crisis volatility hierarchy, all least one of the following three conditions must be met:

1. Sharp deterioration in public finances. This scenario, which would weigh mainly on the long end of the yield curve, cannot be totally ruled out in that not very much is known even now about Donald Trump’s economic policy. What is clear is that if certain measures promised during the election campaign are implemented, they will have a significant impact on the budget. However, in Congress, Republicans are known mainly for their fiscal orthodoxy, so it would be surprising to see them agree to break the mould.

2. The debate over the debt ceiling is moving back centre stage, with this issue likely, in theory, to crimp the federal government’s leeway when it comes to tax cuts and spending. The 2011 fiscal deadlock prompted S&P to downgrade the US sovereign rating. If there is a repeat, long rates (TNotes directly, swap rates indirectly) would come under pressure. However, in that the executive branch and Congress are controlled by the Republican Party it is unlikely they will clash over this issue.

3. Retaliatory measures by China (notably), if it is the victim of protectionist measures decided by Donald Trump. The People’s Bank of China could decide to offload part of its US dollar foreign exchange reserves. That cannot be ruled out, but would not be without risk for the Chinese authorities, as the country would have to cope with an appreciation of its currency and a rise in custom tariffs, which could deal a serious blow to China’s competitiveness.”

“As for real rates, they should be set to emerge from negative territory, even though it is unlikely they will recover rapidly to their pre-crisis levels. At strategic level, this will gradually modify several “laws”. In particular:

1. The slope of the yield will, once again, come to be explained mainly by short rates. The left-hand chart below shows that, pre-crisis, Fed watching was probably one of the most crucial functions in the fixed income market, with the probability that this will be so again going forward.

2. Butterflies, which had become highly correlated the market post-crisis (5-10-30 being a case in point - see yesterday’s Trade Idea), will probably see a gradual change in their behaviour.

3. Volatility displayed by swaptions with short tenors (2 years) should, on average, gradually exceed volatility displayed by swaptions with long tenors (10 years).”