Market Mover - BNP PARIBAS - Investment Services India

This section is classified as non-objective researchits long-run NAIRU, and some disappointment couldresult from such inferences. Still, we believe that tobe a very unlikely outcome and are bullish TIPSheading into the event. The direct result on TIPSbreakevens should also be a continued steepening ofthe curve at the long-end and a potential selloff inUST nominal yields at the long-end along with somefurther “risk-on” response.Looking now at the front-end of the TIPS curve, it hasbeen a bit of an enigma of late, responding moreslowly to WTI oil prices than expected, especiallygiven the recent upswing in WTI crude prices (seechart) which have given the price moves a decidedlypositive technical character. This is likely due to areversal in the Brent WTI crack-spread and thecloser tracking of gasoline with Brent crude ratherthan WTI. Additionally, the backwardation of the WTIcurve after several months in contango cannot betaken as a bullish sign according to our energystrategists, given the temporary and technical natureof the correction and the fact that it could be prone toquick reversal. Front-end breakevens could simplybe anticipating this correction and paying less heedto WTI prices than they might have during priorperiods. We’ll be watching this spread closely,though our view is that for the moment, the structuralchange in the WTI curve is temporary. Our front-endbreakeven steepener with an energy hedge is still upslightly with gasoline prices down since initiation.Turning now to another recent trade idea, we take alook at our 10s-30s BE steepener. After a sharpmove in our favour, the trade has run into sometemporary headwinds, chopping sideways for most ofthe week. From a technicals perspective, the 200-day moving average at 21.5bp (and falling) remainsan impediment to the curve’s further steepening.Leaving that aside for the moment, however, webelieve that 10s-30s still offers the best value(especially heading into month-end), but it also has agreater amount of volatility than the 20s-30s BEsteepener. In fact, the volatility over the last year hasbeen roughly double in the 10s-30s vs the 20s-30sBE curves, which isn’t unexpected. Those wishing toprotect profits in the 10s-30s may switch to the 20s-30s BE steepener as a way to safeguard gains whileretaining the same basic curve view. 20s-30s mayalso offer a closer psychological floor, with the 0bound of the curve only about 3.5bp away. Thecaveat to this, however, is the Fed’s fondness for the20yr sector, which sports very high index ratios andmay be a quick way for the central bank to introducea much greater amount of cash into the system atbuybacks.Another indicator worth watching is 5yr forward 5yrzero coupon inflation swaps, which have retracedfrom their recent lows near 256bp and bounded closeto current levels of 286bp. Here again, we believe arespite might be in the offing, given the sharpness ofthe recent move, but the general trend should bemaintained, and we will likely move higher. This tradeallows another potential way to play the expectedsteepening of the breakeven curve coming out of theFOMC meeting next week.The schedule for November’s purchases and saleswill be released near month-end, and we suspectthat the Fed will once again choose to place thepurchase early in the month and the sell-back closerto the CPI fixing date. We believe this stems from theFed’s desire to schedule the sale as close to a highactivity point for the front-end as possible to allow formore liquidity in the market and perhaps betterdemand. Such a placement should suffice, however,the moving of this sale further away from the CPIfixing is also unlikely to significantly impact demandwhile creating another period of good trade executionfor TIPS. Supply creates its own demand, and a saleoperation by the Fed, as long as it doesn’t coincidewith another major headline event (G20 summit,FOMC meeting, etc) should retain significant demandand provide a more consistent number of liquidityevents in the month rather than focusing most of themonthly activity into a single week. The first TIPSevent saw aggressive buyers, and with CPI only aweek later, we’re likely to see similarly solid demand.We caution that if certain front-end TIPS continue torichen (April and July 12s specifically), they maybecome targets for sale at the next operation. We’lltake another look at those securities once we knowthe schedule and as we get closer to the date. Thebuyback in TIPS should still remain early in themonth, and the Fed is likely to go after its oldfavourites again (April 28s, Apr 29s and Feb 32s)while excluding the July 21s (they now own a smallamount from a SOMA auction purchase).Aaron Kohli 27 October 2011Market Mover57www.GlobalMarkets.bnpparibas.com