US: Sharp increase in spread between the 10-year and 2-year inflation swaps - Natixis

René Defossez, Research Analyst at Natixis, points out that the spread between the US 10-year inflation swap and US 2-year inflation swap has increased sharply since March as two months ago it was near zero and currently, it exceeds 36bp, its highest level since March 2016.

Key Quotes

“Surprising steepening of US inflation swap curve

Econometrically, the spread between the US 10-year inflation swap and US 2year inflation swap should be slight, even negative. Instead, it stands at 36bp, because of the sharp fall of the short-dated inflation swap. It is difficult to find a rational explanation for this state of affairs. In particular, econometrically, the US 2-year inflation swap should be near 2.2%, not at 1.78%. In the short term, the slump in crude oil prices is probably an explanation, but not a sufficient one, as the spread started to widen even before crude oil prices went back on the retreat.”

“Slope should tend towards zero bp

There are good reasons to expect the slope to tend towards zero bp. On Thursday, the Trump administration notched up its first major victory with the repeal of Obamacare. If this success is confirmed by the Senate (which promises to be more arduous), Donald Trump will have more credibility when he goes about pushing through his tax cuts. This should stimulate growth at a time when wages are coming under pressure in several sectors.”

“Strategy characteristics

As a rule, stronger inflation leads to a flattening of the US inflation swap curve, as short-dated swaps are far more sensitive to actual inflation than longer dated swaps.

Having said that, risks associated with this strategy are not nil: at economic level, Q1 was disappointing. Most analysts and the Federal Reserve believe this economic slowdown was temporary and that the trend for the US economy remains good. If this is not the case, and activity falters durably, the strategy playing a contraction of this spread will prove risky. However, we believe, as do many others, that the economic slowdown will prove short-lived. From a tactical standpoint now, it would be dangerous to enter into this trade idea at a time when crude oil prices are declining. One would need to wait at least until there is a stabilisation before playing a contraction of this spread.”