Goldman Sachs: Belly Steepeners, But Long End Flatteners

Goldman Sachs note that "despite a disappointing jobs report and other recent weakness in data, markets appear to be looking through the soft patch - yield curves have steepened and breakevens have widened substantially since the start of the year. Given our view that this weakness is likely to prove temporary, we think the market reaction is appropriate. Traded inflation appears to have largely repriced to the Fed achieving a 2% target; to get additional widening from here, markets would have to start pricing in "extra" premium. Much of the heavy lifting in steepening nominal curves further will then have to come from higher real rates; as we've highlighted previously, long end real rates appear too rich and inconsistent with a successful liftoff of the economy. However, the long end repricing may occur gradually over time. The near term pressures, in our view, are likely to come in the context of an overshoot scenario in the coming months, during which we believe the reflation theme will play out somewhat differently than it has in the early part of the recovery."

• "Specifically, we think there is a strong possibility that markets will get well ahead of actual Fed normalization, forcing belly yields higher (this could occur from both pricing of extra inflation premium in the belly and higher real rates from anticipated Fed policy rate normalization). This means where previously an increase in yields would translate to a steepening of the 5s30s portion of the yield curve, future steepening will be further in - indeed, we had moved our steepener recommendation from vol-weighted 5s30s to 3s10s. Given the greater pressure in the belly than in the long end in such a scenario, we believe the 7s30s curve could flatten by about 15bp or so in such a move (mostly coming from the 10s30s portion of the nominal curve). We therefore recommend adding conditional 7s30s curve flatteners via 3-month expiry payers for a small net premium intake."