Goldman: Sell 5-Year TIPS Hedged With Oil Long

Late on Friday Goldman Sachs noted that “despite oil prices being some 15% or so from local highs and relatively hawkish Fed messaging, traded inflation has proved resilient. The front-end of the inflation curve is close to local highs, while medium-term forwards are only some 5-10bp lower. The relative outperformance of inflation across the curve versus its beta to energy prices has been a feature of recent weeks, suggesting that investors are also requiring compensation for other risks, such as broader supply-chain disruptions (either due to the war, or Covid-related lockdowns in China). Real yields, conversely, have rebounded from local lows, but remain somewhat below levels seen in mid-February. With the market implying an inflation path that is elevated compared to our economists and the Fed’s (pricing headline CPI above 3.5% next year and above 3.1% in 2024), and given the Fed’s focus on managing inflation risk, we think being short real yields offers attractive risk/reward. Absent a significant growth shock, an inflation path closer to what the market is pricing would likely elicit more hikes than the median Fed dots imply, while an inflation path closer to the Fed’s own would imply higher real yields compared to market pricing. The primary near-term risk to this short position is a larger stagflationary oil shock, though the recent relationship of real rates with energy prices suggests some positive convexity to hedging real rate shorts with oil longs. We recommend doing so with a hedge ratio of 17 Jul ‘22 contracts/10K risk.”