Trade Recommendation

Last week’s “what ever it takes” moment announcements from German new Chancellor Merz on breaking the German fiscal debt brakes for increased defense & infrastructure spending might usher in a new rate regime where German bond yields might keep on rising significantly due to higher fiscal deficits. The additional deficit-spending should bring the German budget deficit to 5-6% of GDP initially before the expected growth effects kick in and slowly reduce it back about 4% over the medium term. This implies a steady rise in 10yr German Bund yields to 3.25-3.5% by end CY25. On the UST side of the trade, we believe we are one NFP away from a significant employment shock which might push the Fed to start looking at rate cuts starting from June leading to a total of 3 cuts of 25 bps each in REMCY25. We also believe that the deregulation efforts from the new Trump administration will lead to SLR benefits for UST holdings leading to further increased demand for USTs from G-SIBs. We also see a distinct possibility of QT pause from 1st April (the government shutdown is likely from 14th March) till 30th Sep. This implies a 3.75 level on 10yr UST yields by end CY25. Hence, we are recommending long 10yr UST against short 10yr German Bunds as we expect the current spread at 146 bps to narrow to 50bps by end CY25. Trade Summary: BUY 10YR UST @ 4.30 & SELL 10YR BUNDS @ 2.84 at current spread of 146 bps for a target of 50 bps in the spread. SL at 200 bps spread.

Trump 1st week has passed with out any major announcements on tariffs. While he did make the customary noise about Canada & Mexico, he has been soft on China since day one surprisingly. The lack of immediate tariffs on US trade partners triggered a surprising market response, with sentiment improving around international equities and currencies. While DXY has corrected significantly, US rates are still elevated. Also beyond the above policy silence on tariffs, we are also seeing encouraging signs of rental disinflation. The BLS released its repeat-rent indices this week, pointing to further slowdown in CPI measures of rent and OER. The All-Tenant Regress Rent (ATRR) index decelerated to 3.2% y-o-y in Q4 from 3.9% in Q3. Based upon policy comfort as well as inflation outlook on rentals, we believe we might have a window of fall in short end US yields. But since Trump regime is unpredictable and markets can be quite volatile, we are keeping a wide stop loss and take profit targets. Currently 5yr US SOFR is at 4.12 but we intend to receive it around 4.2 levels to give us some cushion of safety. Trade Recommendation: RECEIVE 5 YEAR US SOFR (INITIATION PRICE 4.20), TP 4.00 & SL 4.4, CMP 4.12

UK 2-year SONIA looks set to test the 4.50 levels sooner than later. Technically it is 76.4% retracement of the entire move between 4.80 & 3.76 levels in the last 1 year. Fiscally, UK economy is in a high service inflation & low growth phase. It's current service inflation level of 5% is way above what is required (3%) to get headline inflation to 2%. In addition, the recent tax hikes has led to flight of growth capital leading to almost zero growth in Oct-Dec'24 which implies weak interest servicing capabilities of the UK government in medium term. The current uptick in UK gilts at a 23-year high is not going to go away immediately until UK Chancellor Reeves slashes spending to cover the rising costs of payments on government debt. The combination of a weaker pound and higher relative gilt yields has echoes of August-September 2022, and if this continues, could potentially be evidence of a buyer’s strike or capital flight from UK bond markets. Summary: PAY 2YR SONIA (CMP 4.38), TP 4.50 & SL 4.28.

We believe the recent fall in UST yields were more a result of index extension as well as asset rebalancing for Nov end. We also believe that US data this week might be strong enough for bond yields to again inch up towards their post Trump win Nov highs. We are looking for a strong US Core CPI no at 0.33% MoM for Nov & 0.28% MoM on headline CPI. Core goods inflation might be back with a bang this month at 0.15% MoM from 0.05% in Oct. We find the current market pricing surprising because in Sep SEP, Fed projected that UR (unemployment rate) by end of CY24 will be at 4.4%, GDP for CY24 will be at 2%, headline PCE will finish CY24 at 2.3% & core PCE will finish CY24 at 2.6%. 10 officials voted for 4 cuts in CY24 & 9 officials voted for 3 cuts in CY24. Coming to present, UR stands at 4.2%, GDP growth for entire CY24 is likely at 2.5%+ & core PCE is likely to be at 2.9% by end of CY24. Ideally, we should have gone paid on 2yr US SOFR but we are recommending to pay 10yr US SOFR because even in the worst case if it is a 25-bps cut, it is most definitely a hawkish cut with DOTS in Dec showing higher neutral around 3.75% & only 2 cuts shown in CY25 by FOMC members. Summary: Pay 10-year US SOFR at CMP of 3.68, TP of 3.98 & SL at 3.48.

We believe the recent fall in UST yields were more a result of index extension as well as asset rebalancing for Nov end. We also believe that US data next week might be strong enough for bond yields to again inch up towards their post Trump Nov highs. We are looking for a strong Nov NFP at 275k with upward revisions to Oct NFP to 75k from 12k. (NFP data due on 6th Dec). As we enter a new week, US economic data such as ISM services & NFP might show that US economy continues to be strong in both employment & macro-outlook. This might lead to repricing of short end wrt to the 60% cut still being priced in for the 18th Dec Fed meet. We also believe that with a terminal rate pricing of 3.75, a term premium of 50 bps & a fiscal deficit of 7% of GDP gives a fair value of 10yr UST around 4.4-4.5 at a very conservative level. Hence, we recommend to pay 5yr US SOFR which is a mix of our short end rate view and long end bearish outlook. Summary: Pay 5-year US SOFR at CMP of 3.75, TP of 4.00 & SL at 3.54.

We believe ECB is more then likely to cut by 50 bps in the 12th Dec meeting. Our reasons stem from the following facts: 1. Significant increase in Russia Ukraine tensions recently. 2. Significantly weaker than expected Nov PMIs for Germany & Eurozone. 3. Eurozone economic growth profile is weakest amongst DMs. 4. It’s large bilateral surplus with the US makes it a target of Trump’s trade agenda. 5. Productivity growth is sluggish. 6. European Central Bank (ECB) policy rate cuts are the easiest path to stimulus. 7. Fiscal resources are limited. While EURUSD has seen a significant fall this week due to above narrative, ECB rate pricing for 12th Dec meet has yet not shifted meaningfully. Market is currently only pricing 48% probability of a 50 bps cut in the 12th Dec meeting. This to us looks a trading opportunity via the 3-month ESTR. We believe next week’s CPI release figures in Eurozone might give us entry in the above trade strategy as we expect the Nov inflation nos to come higher than Oct. Trade Recommendation: Receive 3month ESTR (3-month Euro Swap) at 2.90, SL 3.00, TP 2.70. CMP 2.81. Risks to the view: ECB does a neutral 25 bps cut in 12th Dec meet.