Our medium term views

 Our key forecasts

 What we like right now

  The View

 The week that will be

  The main data prints of the week have yet to come at the time of writing: EA inflation and US non-farm payrolls. Our economists are looking for 2.6% in core HICP and 165k in NFP. Both numbers are likely to be somewhat discounted by the market. Inflation data is distorted by Easter seasonality and the US labor market is unlikely to show any signs of the tariff effect yet.

Markets are likely to pay more attention to next week's central banks. We expect the FOMC and Norges to stay on hold, the BoE to cut and the Riksbank to wait until June to cut again. More interesting than the decisions is likely to be the communication around them, especially the BoE's forecast updates, given the dovish forecast revisions by the BoJ (see below).

We remain received Nov MPC Sonia and are now paid June FOMC OIS. We stick with our US inflation steepeners (1y vs 2y3y) and breakeven longs vs EUR. We return to spread shorts in US 30y after the refunding announcement and would enter 5s30s steepeners on any flattening (see US Rates Watch 30 Apr 25). We closed our front-end US curve flattener (Jul FOMC vs 5y) and our AU flattener vs CAD given the pricing out of emergency cuts by the RBA (see Liquid Insight 1 May 25). We stay long spread duration in EUR rates (15y France).

Finally, the new German government is expected to be sworn in. With the heavy lifting on the debt brake done, the main immediate question for the incoming administration is whether to trigger the escape clause in the 2025 budget to provide more meaningful near-term support. Since this is unlikely to happen without a further deterioration in the outlook, we do not consider it a major risk to our bullish bias in EUR rates.

The week that was

There is an interesting contrast between US and EA inflation and activity data this week.

US core PCE 3m/3m is annualizing at 3.4%, US core services CPI at 4.3%. Both of those before the main impact of tariffs will show up in the data. GDP was weak, but domestic demand strong, with final sales to private domestic purchasers still at 3.0% annualized.

EA core inflation data is likely to come in somewhat higher than expected by consensus, following the national prints. However, the underlying details suggest we could already be seeing the disinflationary effects of tariffs in goods inflation. GDP data was also stronger than expected, but underlying details and correcting for noise from Ireland paint a weaker picture, again before any impact from the trade war.

This asymmetry of risks was also reflected in the latest BoJ forecast revisions. These invalidated our bear flattening bias on the JPY curve but support our bearish FX view (see Liquid Insight 28 Apr 25).

Finally, we think US Treasury missed an opportunity in the quarterly refunding announcement to signal support for the long-end. Buyback operations were left unchanged and there was no discussion of managing the weighted average maturity of issuance to better balance supply and demand.

  Rates - US

• Rates: bad news priced, good news not; eye duration longs & steepeners
• May FOMC = hold, UST refunding = short 30y spreads, stablecoins = important

 Signal miss => cheaper long end USTs

US rates bull steepened this week amidst softening sentiment & moderating labor market data. All eyes will be on the employment report this morning; we expect a larger market reaction to a stronger vs weaker print given extent of Fed cut pricing & whisper number below consensus. We think our economists' forecast of 165k vs consensus 135k could see 5y rates knee-jerk increase 5-10bps & curve bear flatten.

We update our core rate views & adjust trade recommendations; our view is that our long duration & curve steepening bias has worked but current levels appear fair. Bad news is priced, as seen by Polymarket recession odds & Z6 (Exhibit 4). Good news is underpriced as evidenced by relatively stable economic surprises (Exhibit 5). We suggest waiting for some good news before re-engaging long rates & steepeners.

Duration: we see current rate market pricing as fair; we have a long bias given downside growth risks but believe the market's Fed cutting trough around 3% (Fed LR median) is appropriate given balance of risks We recommend buying any rate sell-off with strong payrolls but are reluctant to chase rates lower at current levels.

Curve: steepening bias with long anchored in the curve belly (5y) & short in the very long end (30y). Belly long is consistent with downside growth risks & potential for lower Fed cutting trough. Long end short is due to ongoing supply / demand imbalance. We closed our front-end curve flattening view (pay July '25 FOMC OIS & receive 5y OIS) this week after quick curve flattening & shift lower in 5y OIS (see FOMC preview). Similar to our duration view, we look to add steepening exposure on any market pullback.

Spreads: May UST refunding missed an opportunity to provide support to UST long end & suggests further scope of cheapening (see May refunding). We re-established our 30y short spread position where we entered at -90bps (matched maturity swap vs current Feb 2055 30y), targeting -110bps & stop at -75bps. Risk is surprise in deficit outlook.

Front end: we shift our paid front-end position from July to June '25 FOMC OIS. Our paid July FOMC OIS is closed at 3.99%, above entry level of 3.93% (see Seeking a signal). We now prefer to pay June FOMC OIS at 4.18% given a wait & see Fed (see below). We target 4.30% with a stop at 4.05%. Risk is data softening & June Fed cut.

We continue to hold our July SOFR/FF widener. We expect debt limit resolution in late July / early August & bill cuts of $350b from now till end June (see US front end). We worry about upward funding pressure after July but recommend positioning for that amidst early summer funding stability.

Inflation: we expect front-loaded inflation risk premium to moderate but inflation shock could persist. We recommend short 1y & long 2y3y CPI swaps to position for less inverted inflation curve. Higher realized inflation could bring renewed source of demand for TIPS and compress inflation basis in belly of curve (see Not so fast & furious).

Vol: we take off our 1m fwd 2y30y bull flattener, which performed well into the refunding. We continue to favor 9-12m fwd 5s30s bear steepeners, enter a floor ladder in 2s10s & a receiver calendar in 1y tails (see US vol).

For the remainder of this section, we discuss the May FOMC & UST refunding. We also discuss UST demand from stablecoins, which has potential to disrupt the banking system.

May FOMC: wait & see

US rates expect little from the May FOMC meeting. Powell will likely reiterate the Fed is in no hurry to cut rates & in a wait & see approach given dual tariff employment & inflation threats. The market prices in elevated likelihood of the Fed on hold at this meeting but expects roughly 100bps over '25. Focus will be on the statement & Powell press conference for any shift in Fed's balance of risk assessment or cut willingness.

We expect the May FOMC to reiterate two of our core rate views: (1) pricing of near-term Fed cuts is overdone, and (2) downside growth risk should see cutting trough around 3%. For detail see: May FOMC preview.

May refunding: missed opportunity

In our view, refunding was a missed opportunity for UST to provide support to the long end: reengage 30y spread shorts & eye steepeners. We push back our timing for auction size increases from Nov '25 to Feb '26, bill supply higher. Shorter WAM discussion may come closer to when UST is ready to grow auction sizes. For detail see: May refunding recap.

Stablecoins: demand & disruption

The US Treasury & TBAC have recently been focused on stablecoins as a potential source of UST demand, especially at the front end. We agree.

Stablecoins and US rates matter for near- and medium-term reasons.

Near-term: better regulation & legitimacy of SC reserve assets can increase demand for short USTs, which may help UST justify lower WAM. This is especially true if stablecoin size grows from ~$225b today towards some TBAC cited estimates of $2tn by '28.

Medium-term: SC growth and payment integration could challenge the traditional banking and asset management industry via UST "spendability".

We encourage clients not to dismiss the potential impact of stablecoins on the UST market & banking system over time. See: Stablecoins & USTs: demand & disruption.

Bottom line: bad news is well priced, good news is underpriced. We look to re-engage soft duration long & curve steepeners on any rate rise, which could come after April payrolls. Trades: we pay June FOMC OIS, re-establish 30Y spread shorts, recommend short 1y & long 2y3y CPI swaps, hold July '25 SOFR/FF long, favor 9-12m fwd 5s30s bear steepeners, enter a floor ladder in 2s10s & a receiver calendar in 1y tails.

  Rates - EU

•  We are receiving more questions on potential increased foreign demand for EGBs, as investors assess the renewed de-dollarisation thematic.
• Foreign demand has been on the rise already since 2023, including in German bonds. Latest data from the ECB shows it can still intensify, even without a de-dollarisation push. Allocations at this week's syndications & EPFR flows point to acceleration. The rising FX hedged pick-up in EGBs vs USTs probably support that acceleration.

Foreign demand for EGBs: old theme, new interest

We have been arguing that foreign demand for EGBs would rise as ECB QT accelerates. Indeed, foreign investors have been among the largest sellers of EGBs to the ECB during the QE period and are thus heavily underweight debt securities in their EUR portfolios. Recently released ECB data shows that, based on foreign investors' assets under management as of 4Q24, an increase in their share of EUR debt holdings back to pre-QE levels would require a rebalancing of over €1.6 trillion. This is in addition to the c.€400bn increase in the value of foreign investors' holdings of EUR bonds in 2024 (Exhibit 6).

Foreign investors had indeed started increasing their holdings already in 2023-24. Newly released data from the German finance agency shows that non-EA investors increased their net secondary purchases in 2024 (Exhibit 7), with non-EA private investors' holding rising to 13% of German govt debt securities, from 5% at the end of 2022 (Exhibit 8).

We believe this trend can accelerate, at least with more interest from private investors. EPFR data, although capturing a very small portion of the market, point to increased inflows into EUR fixed income (Exhibit 9), at a time when we saw outflows for US credit funds. EGBs have become more attractive vs USTs (and US corp bonds) on a rolling FX hedged basis. The pickup from 10y OAT over 10y UST on a rolling 3M FX hedged basis rose c. 105bp year-to-date and is near the 2019 levels (Exhibit 10). This was driven by the FX hedge component as ECB rates continued to diverge from Fed rates, which more than compensated for the relative richening of EGB vs UST on ASWs since 2 April.

Our forecast economic & rates baseline imply further increase in the FX hedged pick-up of EGBs over USTs into year-end: from c.60bp currently to c.100bp for 10y Bund over UST, and from c.130bp currently to c.180bp for 10y OAT over UST if the 10y OAT-Bund spread is unchanged by year-end. Levels would be back to the early '23 highs (Exhibit 10).

This week's syndications were also an opportunity to find out if foreign investors (especially official institutions, given the de-dollarisation thematic) are turning more towards EGBs. Allocations suggest this may be the case in France & Finland. Portugal saw higher allocation to core Europe and the Nordics, signalling more appetite for periphery risk.

Implications: increased foreign demand flows from USTs to EGBs on a FX hedged basis should put tightening pressure on the 1M to 3M part of the EUR FX-Sofr basis curve. Flows should also be supportive of semi core and periphery spreads. We still like to be long 15y France to express our bullish duration and spreads view (current: 3.62, target: 3.5, stop: 4.05). The risk to the trade is an idiosyncratic political shock in France.

   Rates - UK

• Next week's MPC shouldn't cause sharp repricing but could help front-end receivers. We buy 30y Gilts on ASW and will be on lookout for slower QT hints.

On the lookout for slower QT hints

 25bp cut with dovish forecasts, but cautious guidance

Our economists expect the BoE to cut Bank Rate by 25bps next week with an 8-1 vote split (Dhingra voting for a 50bps cut), with risks skewed to a more dovish voting pattern.

Reasons behind their call for a cut next week and another three in 2025 (Aug, Sep and Nov): encouraging inflation progress, lower energy prices and emerging downside growth and inflation risks from tariffs. Reasons why we think a larger 50bp cut is unlikely at this stage: lower financial stability risks, better starting point for growth, caution ahead of rise in NICs and inflation uncertainty stemming from impact of tariffs.

We expect BoE forecasts to show lower future growth and inflation, opening the door for faster cuts in the second half of the year. But for now, we expect the BoE to retain the careful, gradual, and meeting-by-meeting guidance amid the uncertainty. Our economists think that Jun or Aug is where the dovish BoE pivot could materialize. But risks of a dovish pivot in May cannot be ruled out, especially if inflation forecast downgrades are bigger than we expect, opening the door for faster cuts already.

Rates already pricing in a cut: our base case outcome should not rock the boat…

The rates market is fully pricing in a 25bp Bank Rate cut from the BoE next week. With 95bp of cuts priced in by Nov, our expected outcome of a cut with dovish forecasts but cautious guidance should not result in a major repricing, but would be helpful at margin for received expressions further out in 2025 where market pricing still falls short of our base case (Exhibit 14).

• We keep our received Nov MPC-dated Sonia entered at 3.66% on 11 Apr (see Rates - UK section of The art of the repeal). Current: 3.54%. Target: 3.46%. Stop: 3.76%. Risk to the trade is an upside inflation surprise.

We also maintain a steepening bias given the possibility of (but not our base case) that terminal rate realises at 3.25% in early 2026 (Exhibit 15).

• We keep our steepener-like short the belly of Sonia 3s5s7s trade entered at
  -12bp on 5 Sep (Back to school: tough tests this term). Current: -6bp. Target: 10bp. Stop: -21bp. Risk to the trade is an upside inflation surprise.

… but QT hints would be important, if they were to materialise

It is probably too soon, but we (and the market) will be on the lookout for any hints regarding the QT pace from October. We think that chances of a slowdown from October are non-zero: the DMO has done its bit; now it is the BoE's turn to adjust (see Revised remit, revised thinking, 23 April).

The slight QT Gilt sales' calendar amendment made on 10 Apr, replacing the scheduled long-dated Gilt operation for 14 Apr with a short-dated one and shifting the long sale to 3Q25, was a signal to us that the Bank is keeping a close eye on market fragility and may be coming round to the idea that QT is having a more meaningful impact on the market (rather than happening "in the background", as desired).

Pill's comments on 23 Apr highlighting that there is a question over whether QT may exacerbate rises in bond yields (although specifically in times of market stress), saying that the Bank is ready to tweak its balance sheet run-off in response to market volatility, supported our view.

We go long 30y Gilts on ASW

Our recently updated forecasts imply Sonia realising broadly along the forwards, but our Gilt yield forecasts lie below the forwards and imply performance relative to Sonia further out on the curve (see Rates - UK section of Double WAMmy, 25 April). QT slowdown theme into late summer is one factor behind this judgement: no active QT from Oct would imply a roughly 20% reduction in long Gilt sales from DMO and BoE relative to current Remit and unchanged QT pace from Oct.

We continue waiting for 2Q to judge foreign demand for Gilts, expecting a rebound from April (see Gilt buying in March: seasonals on show, 1 May). Separately, Gilt pickup analysis might be helpful when thinking of demand ahead and across the curve: for USD investors, 30y Gilts appear the most attractive on a full FX hedged basis among the non-spread products (ie, excluding France, Spain and Italy), but not so on a rolling hedged basis. For a broad range of investors, 30y appears to be the most attractive across the GBP curve on a full FX hedged basis but again less so on FX hedged basis.

More tactically, July being a relatively heavy Gilt coupon payment month, around 40% of the payment amount will be in the long-end (37% in private). We enter new trade idea of long 30y Gilt ASW using benchmark Gilt. We will monitor the trade on z-spread basis:

• Long 30y Gilt on ASW (using UKT 4.375% 2054) at 91bp with a target of 75bp and stop of 100bp. Risk to the trade is re-emergence of UK fiscal worries.

For those keen on cross-market expressions, we would also highlight that our team are back to favouring short 30y USTs on ASW, having been disappointed with the May refunding outcome (see May refunding recap: signal miss. 30 April).

 Rates - AU

Cheap hedges against global risk in AUD basis

AUD rates and basis markets are sending different signals. Even with fixed-income markets pricing a higher probability of deterioration in the macro outlook (wider credit spreads, front-loaded RBA easing cycles) and the RBA's recent decision to reduce its footprint in short-term funding markets¹, the spread between AUD bank bills and OIS (BBSW-OIS basis/ BOB) has tightened from over 25bps on 9 April to around 3bps today.

We close our tactical flattener as BofA's RBA Sentiment Indicator shifts further into dovish territory and recommend investors capitalize on tight BOB spreads as a cheap hedge against elevated global risks. We recommend paying 1y1y BOB because the structure has negligible carry and moved at a high beta to global risk during the reciprocal tariff episode. Entry 13bps, target 25bps, stop 7bps. Risk: tighter credit spreads could pull down 1y1y BOB given the structure is a liquid, high beta proxy for risk

Paying BOB is a hedge against global risks

In the nearer term, BOB is likely to track local and global credit conditions. The supply of bank bills has fallen significantly after spiking during the reciprocal tariffs, risk-off episode around 9 April. Over this period, BOB has been quite volatile, peaking at 25bps and falling to just 4bps today.

Using volumes of bank accepted bills traded in the daily rate set window as a proxy for daily supply, total volumes have fallen from about AUD 3bn to AUD 2bn after a spike during the risk-off episode in early April (Exhibit 18). Paying 1y1y BOB is equivalent to positioning for another spike in the supply of bank bills. In other words, it is a risk-off hedge.

One of the main reasons we like this trade is the shape of the curve. The spread between Dec '25-starting BOB and 1y1y BOB is close to zero (Exhibit 19). The plateau in BOB levels beyond 2025 means the carry of paying BOB is close to zero over the next few months. For investors who prefer to pay 6s3s basis, though, 2y1y 6s3s has positive carry and 6m 6s3s has not tightened as much as BOB.

RBA OMO changes should push BOB wider

Over the longer run, changes to the RBA's open-market operations (OMOs) announced in early April are likely to push spot BOB higher. The RBA Board decided to move from the de facto floor system with excess reserves to an ample reserves regime. For full details, see Australia Watch, 8 April 2025.

These changes mean the RBA would not be required to hold a sizeable buffer of reserves over underlying demand, which leads to a relatively large balance sheet. Excess reserves imply some additional risk to the RBA (e.g. interest rate risk) and a more sizeable footprint in private markets compared to the RBA's new 'ample reserves' system. The OMO changes are designed to increase private market activity and reduce the size of the RBA balance sheet, while reserves are still ample, but likely will lead to slightly more cash rate volatility.

Fair value for BOB around 15bps

Although the link between BOB and bank reserve levels is tenuous, the RBA expects reserves to stabilise around AUD 100-200bn, which implies a fair value of around 15bps. See Exhibit 21. Intuitively, this level makes sense as an approximate halfway point between the COVID-era, when BOB traded around zero, and the pre-COVID era when surplus ES balances were close to zero and BOB traded closer to 30bp.

  Rates - JP

• Lifers to reduce JGB holdings in FY25, mixed on foreign bonds, likely to increase alternative investment.
• JGB curve to continue steepening on lack of demand particularly for 40yr issues

Lifers to further slow superlong JGB purchases

Superlong JGB yields appear to be above Japanese life insurers' assumed interest rate on insurance liabilities, but they are expected to reduce their JGB holdings in FY25. This reflects their reduced need to buy superlong JGBs for ALM purposes, and their expectation for 1-2 BoJ rate hikes within FY25. We would note that some life insurers apparently drew up FY25 investment plans prior to the announcement of the Trump administration's so-called "reciprocal" tariffs, and their investment policies could change considerably depending on the outcome of US-Japan negotiations.

JGB holdings to decline

The five major life insurers' FY25 investment plans indicate that they intend to reduce their JGB holdings (Exhibit 22). While some lifers do plan to increase their holdings, the 28 April Nikkei reported that the nine majors (excluding Sumitomo Life) intend to reduce them by a total of ¥1.3tn in FY25². Given that they increased their holdings by around ¥360bn in FY24, this implies a major shift in their investment strategy for superlong issues in FY25.

However, we do not expect lifers to sell their JGB holdings outright. They simply appear to be slowing their buying of superlong JGBs now that they have nearly finished matching the duration of their assets and liabilities to comply with economic value-based solvency regulations. In short, planned JGB redemptions are expected to exceed planned investment, resulting in a YoY decline in lifers' JGB holdings. They also look set to continue rotating their portfolios from low- to high-yield bonds.

According to JSDA's OTC bond trading data, Japanese lifers' net buying of superlong JGBs has slowed for four straight years, from a peak of ¥7.6tn in FY20 to just in ¥1.2tn FY24 (Exhibit 23). Based on their recently released investment plans, we expect this to shrink again in FY25.

Foreign bonds: Mixed

Some life insurers may increase their holdings of FX-hedged US high-rated corporate bonds, reflecting the decline in domestic investors' FX hedging costs following rate cuts by major developed-market central banks. Their stance on unhedged bonds is mixed.

According to the Ministry of Finance (MOF), Japanese lifers have been net sellers of foreign bonds since FY20 (Exhibit 24). While major FX-hedged sovereign yields remain lower than yields for JGBs with the same maturity, their cautious stance on JGB investments implies their exposure to foreign bonds may not fall as much.

Rates: 30s40s spread could widen

MOF's FY25 JGB issuance plan reduces both 30yr and 40yr issuance by ¥1.2tn versus FY24. However, lifers' FY25 investment plans cast doubt on whether these cuts will be sufficient to offset falling demand for superlong JGBs, and we therefore expect the JGB curve to remain steep.

Domestic investors were net sellers of superlong JGBs in March, the end of Japan's fiscal year, while nonresident investors aggressively bought on weakness. We think nonresidents took losses on flatteners in April. We therefore expect a general lack of demand for superlong JGBs in the near term. Domestic life insurers also look likely to invest mainly in superlong issues in the 20-30yr zone, suggesting a pronounced lack of demand for 40yr issues. This has caused the 30s40s spread to widen to around 42bp, and we see it as unlikely to narrow to the levels around 30bp previously seen in March (for details, see Japan Rates Watch: JSDA March OTC Bond Trading: Domestic investors sell, nonresidents buy the dip 21 April 2025).

  Front end - US

•  Treasury quarterly refunding results in more bill supply & slightly earlier X-date vs prior projections.

QRA prompts bill supply and TGA forecast revisions

Treasury's quarterly refunding announcement has pulled forward our X-date forecast and pushed back our expectations for coupon auction increases (see: May refunding recap). As a result, we revise our forecasts for (1) bill supply (2) TGA / Fed balance sheet.

Later coupon auction growth = higher bill supply

The Treasury's quarterly refunding announcement retained guidance to maintain nominal coupon auction sizes for "at least the next several quarters." We expected this language to be removed and forecasted Treasury would need to begin growing coupon auction sizes by November due to (1) elevated deficits, and (2) to keep a lid on bills as a percent of marketable debt. Retention of this language pushes out our forecast for UST coupon size increases from Nov '25 refunding to Feb '26 refunding. The later increase in coupons will mean more bill supply from Q4 '25 thru FY '27 vs our prior forecasts (Exhibit 25). We now expect coupon auction size increases in '26 to help bring down bills as a % of marketable debt towards 20% by FYE '27. Treasury may be indicating a preference to run bills as % of portfolio larger vs prior TBAC guidance.

Higher financing needs: earlier X-date

Monday's UST financing estimates provided forecasts for Treasury's expected financing need in Q3 '25, which we use as an input into our X-date and TGA forecasts. Due to the debt limit, Treasury can only meet financing needs by issuing a limited amount of net new debt using extraordinary measures or by spending down their cash balance (TGA). A higher financing need in Q3 implies Treasury will hit the X-date sooner than anticipated.

We now expect UST to hit the X-date by mid-Oct (from late Oct) but see Treasury uncomfortably low on cash and extraordinary measures starting in late August (Exhibit 26). Treasury stated their new X-date estimate should be announced in the next couple of weeks. We expect Treasury to provide conservative guidance on the X-date & suggest they lack confidence to stave off default beyond late August. Our base case remains a debt limit resolution by late July or early August, prior to the August Congress recess.

Bills, TGA, & Fed B/S: Sept could see reserve drain

Our late July debt limit resolution is reflected in our forecasts for bill supply, TGA, and Fed balance sheet. Bills = we expect $325b additional cuts into end July & over $900b of net bill issuance from August to November. TGA = rebuild will take place quickly after debt limit resolution & should see TGA back to $850b by end Sept. Fed balance sheet = in Sept ON RRP is expected to reach near zero & reserves could fall below $3tn around the same time, which could see clearer upward funding pressure (Exhibit 27).

Bottom line: Treasury quarterly refunding results in more bill supply & slightly earlier X-date vs prior projections. TGA rebuild could see clearer upward funding pressure in Sept; in Sept we expect ON RRP to reach near zero & for clearer reserve drain.

 Technicals

•  US 10Y yield declined in April which historically favors a lower bias into YE25. Since 1963, yield tended to move lower from a May peak to a June trough.
• For more, please see: Seasonality Advantage: The 90-day warm up 30 April 2025.

 US 10Y Yield: Down April favors a downtrend into YE25

Since 1963, the average trend ending April through July was flat but over the last ten years, the average decline in yield was down by about 10bps (Exhibit 28). US 10Y yield by week in May has shown no strong hit ratio for being up or down (Exhibit 29). If April is a down month (below 4.2053%) then US 10Y tended to be lower until December (Exhibit 29). From mid-May to mid-June in year 1 of the US Presidential cycle, yield declined about 20bps (Exhibit 29). Since 1963, when 10y yield is above the 200d SMA, it tended to rise on Mondays 59% of the time with average gain of 1.14bps. If below the 200d SMA, 10y yield tended to go down on Tuesday by -2.62bps and on Friday by -1.34bps.

   Volatility - US

• We close our tactical 1m fwd 2s10s bull flatteners, stay in 9-12m fwd 5s30s bear steepeners, enter 6m fwd 2s10s floor ladder & long 18m1y vs 6m 1y receivers.

Recent rates move & shifting expectations

In our view, refunding was a missed opportunity for UST to provide support to the long end of the curve (see May refunding recap: signal miss). We recommended a tactical 1m fwd bull flattener in 2s30s (currently +4bp, see May refunding preview: seeking a signal) to position for a potential show of support for the backend in the refunding announcement. With the refunding announcement falling short of our expectations, we recommend closing the position & reevaluate some of our views for vol structures across the curve.

• At the backend: our bias continues to be for bear steepeners in 5s30s with expiries between 9-12m (currently +20bp). The position picks to the fwds and leverages scenarios of more material supply/demand imbalance or shocks to liquidity/funding (see 2022 UK debt sustainability episode - A case study for the US).
• In the 2s10s sector: forwards are pricing a bull steepening trajectory that seems to be reflecting neutral rate expectations c.4% or slightly above (materially above the Fed's HLW r* estimate of 0.79%, which implies a nominal rate c.3% or slightly below). We see scope for the curve to fail to deliver on fwds (e.g., by fading term premium and/or frontend cuts) and favor costless 6m fwd 2s10s floor ladder (target 17bp, stop -10bp). Downside breakeven c.20bp for 2s10s. Risk is flattening dynamic beyond the downside breakeven with potentially unlimited downside.
• At the front end: the expectations for the curve are more uncertain. In scenarios where the Fed regains optionality through a recoupling of inflation to lower growth expectations, the market may frontload cuts and 2s5s may bull steepen. Conversely, in scenarios where the administration delivers on trade deals & likelihood of recession fades (see Exhibit 31), the curve may bear flatten. We see risks for the latter frontloaded and the former backloaded & favor selling 6m1y vs buying 18m1y receiver calendar (vega weighted & costless indicative, target 30bp, stop -15bp). Risk is frontloading of cuts near-term and fading medium term, with potentially unlimited downside.

 Rates Alpha trade recommendations