J.P.Morgan Look To Position For Higher 5-Year Real Yields

J.P.Morgan note that "TIPS still appear rich at current levels. Notably, as we have pointed out in recent weeks, a sharp divergence in signals coming from TIPS and nominal Treasury markets has emerged since late June: front-end breakevens are once again implying a risk that some portion of this year's inflation rise will prove persistent. Meanwhile, the bull flattening of the nominal yield curve has pushed the market-implied Fed tightening path to its most benign since January, with OIS forwards priced for just two full 25bp hikes in the 24 months following liftoff. These factors together have pushed 1Yx4-Year real yields back towards their all-time lows, suggesting perhaps that markets are fearful of stagflation. However, we think the risks of such an outcome are overpriced in the current environment and recommend positioning for higher real yields, for a number of reasons."

• "First, while we acknowledge the risks to growth emanating from the delta wave and a potential pullback in mobility, our tracking of hospitalisation growth rates as well as the experience of the UK and elsewhere imply that the U.S. could be approaching a peak in cases, and we continue to argue that progress on vaccines should limit the links between the virus and real activity."
• "Second, as a corollary, we think it's unlikely that pressures on global supply chains amid rising infections would pressure inflation higher as aggregate demand dropped."
• "Third, if we instead see continued above trend growth into next year as we expect, allowing for continued labour market tightening and above-target inflation, consistent with what's implied by front-end breakevens, we would expect to see markets pull forward Fed liftoff projections and also price a steeper tightening path over the coming years - which would also justify higher real yields."
• "Against this fundamental backdrop, we think that the current level of 5-Year real yields near all-time lows is not justified and like positioning for higher real yields over the medium term. To mitigate the negative carry associated with a short in 5-Year TIPS, we recommend selling Apr '26 TIPS versus a 14% long in Apr '22 TIPS. From a relative value perspective, we also note that Apr '22s are trading roughly 9bp cheap on a nominal z-spread basis and cheap to our spline curve, while hot run 5-Year TIPS are trading close to in line with our fitted curve model." The weighted spread when they recommended the position sat at 140.6bp. One-month carry is -0.3bp and roll is -0.5bp."