Exactly one week after Goldman became the first major bank to raise its 10Y yield target from 3.00% to 3.25%, this morning BofA was delighted to follow in Goldman's footsteps and also revised its 10Y year-end forecast to 3.25%, given "above-potential growth and worsening supply/demand dynamic," the bank's rates strategist Mark Cabana wrote.
Here are BofA's highlights:
- We revise our 10y forecast to 3.25% for end of year driven by above-potential growth and a worsening supply/demand dynamic.
- We switch our position on the curve to a 5y-30y curve flattener given Fed tightening and pension demand.
- Regulatory changes may also end up being supportive of higher rates.
BofA's rate forecast consists of two parts: one for the first quarter, where the bank expects 2.85% to hold, and then for year end, which it now sees as rising to 3.25%.
Coming into this year, we had an out of consensus US 10y rate forecast of 2.85% for end 1Q18. Our thesis was that rates were set to rise as a result of improved growth and inflation via tax reform as well as a worsening supply picture. The market has caught up with our view and we continue to believe rates can reprice higher. We adjust our forecasts to remain above consensus and forwards.
We now expect the 10Y rate to reach 3.25% by the end of the year driven by above-potential growth and a worsening supply / demand dynamic. However, this transition will likely be a bumpy one due to the interplay between rates and risk assets. We continue to believe the 30Y part of the curve will be well supported as a result of ongoing pension-related demand.
Looking at the recent rip higher in yields, BofA believes that "rates in the US can continue to reprice higher and adjust our forecasts to remain above consensus and forwards (Table 1, Chart 1)" as a result of "the combination of solid growth, normalizing inflation, and higher deficits / Fed portfolio reduction should see yields rise further."
The highlights from the bank's revisions:
- Long end: Our end Q1 10Y forecast remains at 2.85% given positioning and the potential for additional near-term risk off as rates shift higher. We now expect the 10Y rate to reach 3.25% by the end of the year driven by improved growth and a worsening supply / demand dynamic but expect the push and pull between rates and risk assets to make this transition a bumpy one. We continue to believe the 30Y part of the curve will be well supported as a result of ongoing pension-related demand.
- Front end: We see the front end of the curve (2Y & 5Y) as having the greatest potential to rise in relation to forwards as the Fed continues on their gradual rate tightening path. The concentration of front-end US Treasury issuance will also likely contribute to further short-dated Treasury cheapening in the near term. We have also revised higher our LIBOR forecasts given the recent tightening in USD funding and the potential for funding to remain strained in the near term due to elevated front end supply, repatriation uncertainty, and Fed reserve draining.
To summarize, the Bank maintains its view noted at the start of the year that improving U.S. growth and inflation - given the Trump tax cuts - would be met with more supply to push yields higher. And with 10Y rates already trading beyond their 2.85% forecast for end of 1Q and 2.9% for end 2018, the bank is boosting the year-end call to 3.25% "to remain above consensus and forwards."
On the supply side, echoing a warning made by Goldman a month ago, BofA warns that the Treasury needs to increase borrowing substantially in the current and next fiscal year as a result of worsening deficits and the Fed B/S unwind, and that US borrowing needs “to nearly double versus last year to be over $1t in each of next two fiscal years,” to wit:
We believe the US Treasury needs to increase net borrowing substantially in FY '18 & FY '19 as a result of worse fiscal deficits and the Fed balance sheet unwind. We expect that Treasury's total borrowing needs will need to nearly double versus last year to be over $1tn in each of the next two fiscal years. This issuance is slated to be most concentrated towards the front end of the curve and should contribute to a further cheapening of short-dated Treasuries.
From the demand side, we continue to hold the view that existing Treasury buying won't be sufficient to make up for the increase in supply at the current level of rates. We expect 2018 to see lower demand from foreign private and domestic banks compared to the past few years. Regulatory factors could also worsen Treasury demand. While this will likely be partially offset by foreign official and pension buying, we think rates will need to rise to attract sufficient demand.
Putting a number to the forecast, BofA predicts that $1.45 trillion in 10Y equivalent duration will come into the market in calendar year 2018, an increase of $165b from last year.
On the demand side, Bofa continues "to hold the view that existing Treasury buying won’t be sufficient to make up for the increase in supply at the current level of rates" and expect 2018 to "see lower demand from foreign private and domestic banks compared to the past few years" as regulatory factors could also worsen Treasury demand.
The bank keeps a close eye on Japanese demand which could be the wildcard:
Foreign private investors, particularly Japanese banks and life insurance companies, would have to face increasingly challenging funding pressure (Chart 5) as the Fed continued to hike rates, as well as a less favorable currency-hedged yield level compared to JGBs (Chart 6). Japan private investors have turned net sellers of overseas fixed income in 2017, and the latest data (as of 2/16) shows the largest 4-week net selling flow since December 2014, according to Japan Ministry of Finance data.
The domestic side is also problematic:
Within domestic banks, HQLA requirements may decline as regulations are tweaked, and as the Fed continues hiking, higher IOER rates may increasingly compete with front-end US Treasuries. By the end of this year, IOER should yield above 2% and may cannibalize demand for 2-5Y Treasuries given that reserves are virtually risk free and zero duration. Year to date, banks have only bought roughly $2bn Treasuries, compared to $17bn in 2017 and $13bn in 2016 over the same period.
BofA then lists the following adverse regulatory developments:
Supplemental leverage ratio: Recent reporting indicates that the Fed may be leaning towards only adjusting the SLR numerator and not exempting Treasuries from the SLR denominator. This may result in less bank demand for Treasuries vs what some market participants may be expecting. This possibility led us to recently close our 30Y swap spread widener view.
Medium size bank oversight: Senate bill 2155 currently proposes reducing enhanced oversight for medium sized financial institutions and raising the bank asset threshold for enhanced prudential oversight from $50bn to $250bn. This would reduce the amount of liquidity and HQLA that medium sized banks need to hold, potentially cheapening front end USTs.
Liquidity coverage requirements: Any reduction in HQLA need or a broadening of the HQLA definition to incorporate agencies, supranationals, or municipalities as higher quality assets could serve to reduce the amount of USTs that banks hold and be negative for USTs on net.
In terms of trades, BofA started the year favoring a steeper yield curve yet their "conviction in that view has faded with some of the recent re-pricing we have seen. With the Fed set to continue gradually tightening policy, we see the front end of the curve (2Y & 5Y) as having the greatest potential to rise in relation to forwards."
This leads to the new trade reco: a 5s30s flattener:
In a higher rate scenario, we think the 5y-30y flattener would also benefit from increased pension demand in the 30y sector due to improving funded ratios.
A simple model of yields based on the path of policy rates gives a framework to compare rate changes versus forwards in various Fed policy scenarios. In this context, if 3 hikes are delivered this year and expectations are priced for 3 hikes in 2019 and 1 more in 2020, the 5y rate could be 40bp higher than forwards by year-end (accounting for rolldown) while 2y rates and 30y rates would potentially rise less versus forwards. A more hawkish scenario in which 4 hikes are delivered in 2018 and 4 hikes are priced for 2019 would, in this framework, put 5y rates about 70bp above forwards by year-end, with 2y rates 50bp above forwards and 30y rate 40bp above forwards. As a result, we would expect the 5y point to underperform on the curve, and our preferred curve view would be a 5y-30y flattener. We think 5y-30y can also flatten in the more dovish scenario where only 2 hikes are delivered this year and market prices no further hikes in the future.
In a higher rate scenario, we think the 5y-30y flattener would also benefit from increased pension demand in the 30y sector. At higher rate levels, funded ratios improve as liabilities are discounted at higher rates, and this could lead to a stickier 30y sector in a rising rate environment.
Given these views, we are switching our position on the curve. We initiate a 5y-30y cash curve flattener at current levels of 55 bps with a target of 15 bps and a stop of 75 bps. Risks are discussed in greater detail below, but are related to a sharp risk off episode or shift to Fed price level targeting. We close our previously held 2y-10y swap curve steepener at 47bps after having initiated it at 45bps in November.
Finally, listing the risks, BofA highlights that the biggest threat to its bearish view is a sharp unwind of the near record shorts, causing a squeeze anda a "rapid unwind":
Positioning data captured by the CFTC indicates a large net short in Treasury futures across the non-hedging segment of futures positions. Our study of futures positioning shows that extreme positions can be vulnerable to a rapid unwind which in this case could aggravate a rate rally. However, extreme positioning does not necessarily imply a rate rally and short spec positions could be sustained for a prolonged period if justified by strong fundamentals.
In addition, BofA notes lingering uncertainties around the global economic sensitivity to higher interest rates, and especially the overlevered US consumer, something we touched upon earlier this week:
"While US consumers deleveraged following the 2008 crisis, current levels of consumer credit relative to GDP are now at an all-time high, substantially above levels seen in the 2004-2006 rate cycle. With a higher consumer beta on financial conditions, the ongoing unwind of easy policy may produce unexpected disruptions to consumer spending. It is not just the level of rates, however, that will impact consumers, but also the pace of rate changes. As the Fed remains committed to a slow pace of hikes (quarterly at most), we think the consumer will adjust accordingly."
Finally, a key risk to the bank's 5y-30y curve flattening view "is a potential shift in Fed policy towards price-level targeting. While Fed discussions around such a policy change are still at the early stages, the market appears very sensitive to such a shift." The good news is that for now, an "actual change in framework is unlikely for some time, making this a relatively small near-term risk."