For those who aren’t familiar, one of the most entertaining reads on the Street is Deutsche Bank’s Aleksandar Kocic who writes the derivatives section of the bank’s weekly report on US FI.
Last September, he famously referred to the Fed’s admission that global financial markets are part and parcel of the FOMC’s reaction function as “removing the fourth wall,” a brilliant reference to the shattering of the stage illusion when the imaginary barrier between observer (audience) and observed (actors) is broken.
This week, Kocic is out with an analysis of a dynamic we’ve been discussing at length lately: the repricing of the US back-end on the basis (no pun intended) of higher costs for foreigners hedging FX exposure. Basically, the yield pickup is disappearing or has disappeared altogether in 10s.
(Chart: Deutsche Bank)
So how long should we expect the sell-off ….
… in rates to persist? And what dynamics will affect it going forward? Here’s Kocic to explain:
“The debates about possible changes in Central banks’ demand functions started with BoJ. The idea was to resteepen the domestic curve by pushing the short end further into negative territory, while reducing the purchases at the back end. This was the trigger of curve steepning which we saw in September. It appears to be even more intense than the flattening that preceded it – in just two weeks, 5s/30s steepened by 20bp, mostly on the back of the real money positioning and duration extension post-Brexit. While there are no expectations of immediate changes in the Fed actions along the same lines as in Japan, the absence of foreigners at the back end UST was sufficient to cause significant repricing of risk premia there. Additional steepening bias is related to political developments as both leading candidates are making preliminary commitments to further fiscal spending. With the Fed on hold and the USD stable at current levels, it is likely that we will reach a point at which, after sufficient amount of sell off, back-end UST would become attractive again. This would bring foreign (and/or domestic) buyers and slow down or partially reverse the existing trend. If the Fed hikes in 2016, these levels could move even higher as stronger USD and wider basis would imply higher costs of currency hedging. Our view is consistent with a possibility of limited amount of curve steepening, about 15-20bp, in the near term and we remain buyers of conditional and leverage steepeners in the 5s/30s.”