Interest Rate Derivatives Strong data, tighter liquidity con...-110614850

1Srini Ramaswamy AC (1-415) 315-8117srini.ramaswamy@jpmorgan.comJ.P. Morgan Securities LLCIpek Ozil (1-212) 834-2305ipek.ozil@jpmorgan.comJ.P. Morgan Securities LLCPhilip Michaelides (1-212) 834-2096philip.michaelides@jpmchase.comJ.P. Morgan Securities LLCArjun Parikh (1-212) 834-4436arjun.parikh@jpmchase.comJ.P. Morgan Securities LLCNorth America Fixed Income Strategy04 October 2024J P M O R G A N•Data was generally strong even before Friday, but the strong employment report has caused Fed expectations to shift towards shallower cuts. Peering under the hood, policy uncertainty is back - the implied probability distribution inferred from options on M5 SOFR futures is consistent with significant weights being placed on scenarios where the funds rate falls a mere 50bp, and other scenarios involving 200bp in rate cuts. Policy uncertainty typically amplifies the sensitivity of yields to data - with inflation data just around the corner, this is a key reason to turn bullish on volatility in shorter tails. Longer tails are less impacted by this, and we turn bear-ish on short expiry volatility in longer tails•Earlier this week, signs of stress were apparent in repo markets - GC repo and SOFR spiked to 10bp and 5bp over the top of the Fed’s target range, as Reserves fell to below $3.1tn. Of course, seasonal factors around quarter end were at play, but there is information in the magnitude of the seasonal rise in repo rates this quarter, relative to previous quarters. Of note, the move in SOFR this time was only modestly below the rise in around the end of 2Q19, which suggests that the repo market stresses that unfolded in 3Q19 may be uncomfortably close•Going forward, with Reserves and RRP both likely to exhibit inelastic behavior, and given uncomfortable parallels with 2019, we reiterate our expectation that QT will likely come to a halt in the near future, likely by year end, as the Fed will likely choose to be proactive in forestalling repo market stress rather than responding to it afterwards. The SRF is unlikely to be effective in capping repo rates, as indeed it wasn’t this week. But even if it were to somehow work perfectly in the event of repo market stress, SRF usage would increase Fed balance sheet size. Given the same resulting optics as a proactive halt to QT, we think the Fed is likely to begin the process of bringing QT to a halt relatively soon•With geopolitical tensions on the rise, we revisit the question of whether there is a way to position for that via swap spreads. Front end swap spread wideners are not the answer, but there is evidence that term funding premium tends to rise in periods marked by such tensions. As a consequence, swap spread curves are likely biased flatter going forward. Given this backdrop, as well as valuations that are narrow in 3s and modestly wide in 30s, we now recommend initiating exposure to a flatter 3s/30s swap spread curve•Front end spreads outperformed modestly this week, likely because of the balance of