US: Markets not expecting much at the short end

The analysis team at BNP Paribas suggests that Fed is not likely to hike in September, but will likely announce normalization and in addition markets are no expecting much at the short end side of rates.

Key Quotes

“In the US, we have been more agnostic on the short end, expressing our short bias in the long end or via steepeners. Post-June CPI report, markets are sending signals consistent with fewer hikes through 2018 than the FOMC medians (4):

Rate-hike pricing: Markets entered January pricing 2.5 hikes for 2017 and 2 for 2018. Now, markets expect ½ a hike left in 2017 and only 1 for 2018. As 2017 has progressed and the Fed hiked in March and June, naturally the additional hikes priced for 2017 fell. However, ½ a hike over 5 ½ months is not much, and the drop from 2 hikes to 1 in 2018 is telling.
Low vol and no skew: Ordinarily, we express implied volatility in annualized basis point vol. However, vol, such as 6m2y, has fallen below 3bp/day – unseen consistently since before the taper tantrum. Further, both the +25bp payer and the -25bp receiver are priced at very little skew to the at-the-money (atm) options. This was last seen around the Brexit vote. Around the taper tantrum, rates were lower than now, and payer skew was at a large premium to receiver skew.
What does it mean? Fed funds futures show little chance of the hiking campaign going much further. Vol markets are saying they expect little day-to-day movement around short-end forwards (low vol) and perhaps less chance of these forwards repricing measurably and abruptly (low skew). Neither a short nor a long looks all that appetizing in the front end.”

“Chair Yellen did not tie balance sheet normalization to inflation. Therefore, the Fed is not likely to hike in September, but will likely announce normalization. With longer end rates in the US perhaps not as cheap as elsewhere (10y term premium = -18bp) and the front end more anchored by inflation, we continue to favour our 2y fwd 2s5s steepener and 1y10y payer spread.”

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