If yesterday Goldman was pitching going long of the S&P in AUD terms (the world renowned Goldman newsletter may cost $29.95 but is only paid in soft dollars) as its first revealed Top Trade of 2014, today's follow up exposes Top Trade #2: which is to "Go long 5-year EONIA vs. short 5-year US Treasuries." Goldman adds: "The yield differential between these two financial instruments is currently -61bp, and we expect it to reach around -130bp. On the forwards, the differential is priced at around -95bp at the end of 2014 at the time of writing. We have set the stop-loss on the trade at a spread of -35bp. The choice of Treasuries over OIS or LIBOR on the short leg is motivated by the fact that yields on the former could underperform more than they have already in relative space as the Fed scales down its asset purchase program."
More from Goldman on this trade recommendation:
- We unveil today the second of our Top Trade recommendations for 2014
- Long 5-year EONIA vs. short 5-year US Treasuries at -61bp for a target of -130bp
- The spread is already priced to widen in the forwards, led mostly by the US leg
- We look for a bigger term premium at the belly of the US curve ...
- ...while disinflation and the AQR should preserve the ECB’s easing bias
We present today the second of our Top Trade recommendations for 2014: long Euro area 5-year rates vs short their US counterparts. Specifically, we recommend receiving 5-year EONIA fixed rates against shorting 5-year US Treasury Notes. The yield differential between these two financial instruments is currently -61bp, and we expect it to reach around -130bp. On the forwards, the differential is priced at around -95bp at the end of 2014 at the time of writing. We have set the stop-loss on the trade at a spread of -35bp. The choice of Treasuries over OIS or LIBOR on the short leg is motivated by the fact that yields on the former could underperform more than they have already in relative space as the Fed scales down its asset purchase program. We will, however, be watching to see if the decline in US borrowing requirements more than compensates for these effects. The greater liquidity of 5-year Treasuries compared with 5-year US$ OIS has also been a consideration. In the Euro area, we are of the view that German bonds may ‘cheapen’ further relative to EONIA as fixed income portfolios are rebalanced in favour of higher-yielding securities, particularly if the ECB eases further. Three macro factors underpin our new Top Trade recommendation, which we review in the sections below.
Separately, and from a tactical standpoint, we now recommend going long Mar-14 Australian Bank bill futures (IRH4) (see Trade Update: Position for further RBA easing, published earlier today). Our view is that the weakness in the Australian economy will remain in place through 2014. As such, we expect the RBA to cut rates by a further 25bp, most likely by the March policy meeting, with a move as early as in December quite possible. At this point, we believe the market only discounts a 25% chance of an easing move in March.
1. Growth Differential Widens
We expect real GDP growth to accelerate across the major developed economies over the coming quarters. As economic activity picks up speed, and core inflation slowly makes its way back up, we expect intermediate maturity yields to re-price higher. Against this backdrop, we note that:
- On our central forecasts, these dynamics are likely to materialize sooner and faster in the US than in the Euro area. In the former, we project sequential quarter-on-quarter annualized real GDP growth of 3.0%-3.5% during most of 2014 and 2015 – an above-trend expansion, following three years with growth close to its potential rate. We also expect an improvement in the economic outlook in the Euro area, but with GDP growth heading to around 1.0%-1.5% - roughly the potential rate of growth - over the corresponding period.
- Our 2014 GDP growth forecast for the Euro area is in line with the latest consensus (as collated by Consensus Economics), while our US GDP forecast is around 50bp above consensus. The downside skew to our crude oil forecasts (we see Brent at US$105/bbl at the end of 2014, from US$110/bbl at end-2013) could benefit the US economy more than Europe’s, given the larger pass-through to retail gasoline prices, which would support household disposable income.
- Downside risks to economic activity are arguably higher in the Euro area than in the US. As we have written in the past (See Global Viewpoint EMU Policies and Market Implications, October 21), ‘banking union’ represents a key institutional upgrade, which will help contain systemic risks and, over time, support the recovery. The transition towards it, however, presents several challenges. A further deleveraging of banks’ balance sheets and the possibility of private creditor ‘bail-ins' as the Comprehensive Assessment is carried out could weigh on growth more than we already anticipate.
2. Service Price Inflation Diverges
Recent data show that consumer price inflation has stabilized in the US, while it is still trending downwards in the Euro area. Our forecasts indicate that the ongoing divergence in price dynamics on the two sides of the Atlantic will extend into next year: US CPI inflation is seen increasing from an estimated 1.5% in 2013 to 1.7% in 2014, while Euro area inflation goes from 1.4% to 1.1%, with no inflection point expected until the third quarter of 2014.
A significant cross-country divergence in inflation dynamics is also evident when looking beneath the surface (i.e., headline numbers), and accounting for the common international effect of lower commodity prices on retail prices. We notice that services, which typically exhibit a ‘sticky’ or persistent price behaviour, represent about half of the total CPI basket in the US and in the Euro area, and more than two-thirds of ‘core’ CPI. The spread between service price inflation in the US and the Euro area is wide, and possibly set to increase. According to the latest available data, inflation in this category is running at 2.3% in the US, and at just 1.2% in the Euro area. Our econometric estimates of trend service inflation, derived through an econometric approach following the methodology proposed by Stock-Watson (2007), point to an acceleration in the US and, by constrast, a deceleration in the Euro area.
3. Forward Guidance is in the Price
Our 2014 outlook is characterized by central banks cementing their ‘forward guidance’ on policy rates. Currently, a very accommodative monetary policy stance is largely priced in the US, while the market is underestimating the possibility that the ECB can provide further easing, even by cutting the deposit rate below zero. More specifically:
The US$ OIS curve discounts that Fed Funds rates will be kept low for all of 2014 and most of 2015. The 3-month US$ OIS rate in 2-years’ time is around 75bp, back to the levels it stood at in June. The US$ OIS curve steepens considerably beyond this horizon, with the 3-month US$ OIS rate in 3-years’ time currently at 1.65%. But this is just in line with our (dovish) Fed fund forecasts, indicating that the ‘ex-ante’ risk premium is extremely limited. In our previous work, we have shown that estimations of the ‘ex-post’ risk premium in the Eurodollar strip is also very depressed (i.e., investors price negative returns on cash through early 2017) conditioning for the current macro outlook. As we transition to an above-trend growth environment in 2014 and the tapering of Fed bond purchases gets underway, we believe investors may start to challenge the ‘time inconsistency’ of the Fed’s approach, and test its commitment to keep front-end rates so depressed for so long.
In the Euro area, the front end of yield curve is priced ‘fairly’ relative to our baseline views: the 3-month EONIA in 2-years’ time is currently at around 45bp, increasing to 100bp in the following year. That said, ECB officials have on several occasions said that they judge the costs of deviations from their central objective to keep inflation ‘close but below 2%’ as symmetrical, and may be prepared to ease further should disinflation become more entrenched. Even on our more optimistic central scenario for CPI (the annual inflation on our economists’ forecasts does not fall much below 1%), we expect the ECB to offset any sell-off emanating from developments in the US and any negative shock occurring in the Euro area while the Asset Quality Review gets underway.
All told, we see room for markets to re-price US rates higher during 2014 without much spillover into EUR rates. To be sure, our US economists expect the Federal Reserve to strengthen its forward guidance in March when tapering begins. As discussed above, however, this outcome appears to us already largely reflected in the forwards and its announcement could result in a steepening of the curve, as investors discount that more aggressive easing in the near term would result in more tightening later.
4. The Risks to the Trade
We see the main risks to this recommended trade coming from two sides:
The first is timing. The market reaction to the strengthening of ‘forward guidance’ could, contrary to our expectations, be associated with a flattening of the 2-5-year US curve, at least initially, as investors try to squeeze more ‘carry and roll down’ from the US term structure (for a 5-year UST note, the latter is currently in the region of 70bp per annum). Although the EONIA curve would also likely move in the same direction, the net result could be a tightening of the US-Euro area rates differential instead of the widening we expect. Under our central assumptions for growth and inflation, we would view such an outcome as an opportunity to build up positions in the direction we suggest, as the anchoring to short-term rates should result in an easing of US financial conditions, and increase inflation expectations.
The second risk, as is always the case, stems from the fact that our macro forecasts may not be realized, or at least not to the extent that they ‘beat the forwards’. Evidence of a softer US growth trajectory than we currently anticipate could, for instance, delay the tapering of Fed bond purchases and lead to a flattening rally in the US curve, led by the Treasury curve. This risk is amplified by the large consensus that growth will improve next year (albeit at a slower pace than we project). On the Euro area side, the trade we recommend would suffer from a faster normalization of inflation, which could lead market participants to reassess the ECB’s easing bias.