J.P.Morgan Recommend Longs In 5Yx5Y Breakevens

J.P.Morgan note that “even after today’s outperformance, 10-year breakevens appear roughly 30bp too narrow after controlling for nominal yields, oil prices, realized core CPI inflation, credit spreads, and the share of the TIPS market held by the Fed.”

• “While our baseline forecast is that core inflation will cool off quickly over the balance of the year, we still forecast a close-to-3% pace in 2023, alongside still-tight labor markets and structural imbalances in rental markets. Meanwhile, we acknowledge a number of upside risks to our medium-term inflation forecasts, particularly given that we have underestimated the inflationary pressures in food prices over the past year, and that structural shifts may prevent core goods inflation from returning toward the near 0% pace we observed over much of the decade prior to the pandemic.”
• “Moreover, increasing recession fears have no doubt played a role in the cheapening of breakevens since mid-June, but we think volatility and liquidity dynamics have also been contributed to the outsized moves. Our TIPS market depth proxy, calculated as average TIPS trading volumes relative to realized volatility in 10-Year breakevens, has fallen below levels observed in the spring of 2020. Moreover, it has likely also been more challenging for dealers to act as an intermediary, especially in less-liquid off-the-run TIPS: Primary dealer inventories of off-the-run TIPS have risen sharply in recent months to near multi-year highs. Against this backdrop, it is not surprising that cash breakevens have underperformed versus inflation swaps. This has been particularly true in the 10-year sector, where the basis is trading near multi-year wides. As a result, on a forward basis, 5Yx5Y forward breakevens, derived from our par curves, now appears cheaper to inflation swaps than they have at any point in the last 5 years.”
• “With today’s Fed meeting behind us, and the FOMC arguably closer to the end of the tightening cycle and returning to a more data-dependent approach to policy-making, we are comfortable stepping off the sidelines to take advantage of these dislocations. We acknowledge that significant macroeconomic uncertainty remains, suggesting that heightened volatility may persist at least over the near term. However, we think fundamentals argue for wider breakevens over the medium term, and we recommend longs in 5Yx5Y breakevens at current levels “