Goldman: More Room For Intermediate Yield Repricing Despite Reversal

Goldman Sachs note that “an apparent de-escalation in the Russia/Ukraine war last Monday led to a decline in yields from recent highs. Although comments from both sides since suggest actual changes to the situation are somewhat unclear, markets have nonetheless priced out some of the inflationary impact of the war. Alongside the decline in inflation pricing, front end real yields have risen, potentially reflecting diminished negative tail risks to growth, which could allow for more Fed tightening. Friday’s strong jobs report and somewhat weaker than expected ISM report did not fundamentally alter the relative pricing of real/inflation components; inflation pricing remains above the Fed’s target beyond a 2-Year horizon even as markets are placing relatively high odds on scenarios involving rate cuts - the 1Y2Y/3Y2Y OIS curve is inverted by roughly 75bp. As the Fed progresses through the rate hike cycle and the recovery remains in place, we expect some of these forward yields will reprice higher even as the inversion persists (or deepens). One way to position for higher yields in this sector is by selling ATM 6m expiry 2Y2Y mid-curve receivers, which takes advantage of both the better rate levels from inversion, and elevated mid-curve volatility to gain short exposure. The trade carries positively, and has a breakeven of roughly 60bp below spot levels. The risk to the trade is markets pricing higher recession odds while simultaneously lowering the terminal rate pricing, something we view as unlikely given our near-term inflation outlook.”