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​UBS: investors' liquidity preference could shift to cash from swaps

Xinhua Financein CFBOND
2018-09-30 10:12

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The United Bank of Switzerland (UBS), the largest European financial group, in a recently-released report said "investors' liquidity preference could shift to cash from swaps."

The report, titled Global Rates Landscape: A fresh look at effects of fiscal expansion on US long-term interest rates, said, "Therefore, we recommend a 3-year swap spread widener. The trade carries positively and should benefit if the credit spreads widen or uncertainty increases."

With the U.S. central bank's Federal Open Market Committee (FOMC) raising the federal funds rate by 25 basis points on Wednesday, moving the range of the rate to between 2 percent and 2.25 percent from 1.75 percent to 2 percent and pointing to a potential rise at its December meeting, the report caught much attention.

The latest move is the third time the U.S. central bank has raised its key interest rate this year, and the eighth time since 2015. The central banks of the Philippines, the State of Bahrain, the Kingdom of Saudi Arabia and the United Arab Emirates announced on Thursday that they were raising their interest rates by 25-50 basis points (BPS) on Friday "to further anchor inflation expectations and to safeguard the inflation target over the policy horizon."

Results in the report attribute a much larger explanatory role to cyclical variables (e.g. inflation expectations, short-term policy rates) than expectations of fiscal deficits (and bond supply), particularly so after 2000, and more so post global financial crisis. The supply has had more impact on the front end recently, likely as a result of technical or temporary factors.

According to the report, the London Interbank Offered Rate (Libor) is trading at very tight levels relative to the Treasuries for the U.S. "Based on historical experience, we assess the fair-value of the Libor-OIS (Overnight Index Swap) basis to be ~30-40 bps, wider than current spot and forward levels,"

The Euro Area fixed income markets have been caught in the whirlpool of Italian politics and budget negotiations over the past few months, according to the report. Analysts of the UBS suggest that under a modest fiscal expansion (in line with the commentary from Italian leaders), the l0-year fixed-coupon-rate bond (BTP) vs. bond spread can be compressed to 220bps. The 5-year point should be the major beneficiary in such a scenario, and the UBS favors buying the belly in 2s5sl0s BTP on regression. With the absent of any major risk escalations, the UBS expects core yields in the Euro Area to rise gradually towards the year-end alongside steeper curves, but adjusted its l0-year Bond yield forecast downward.

After the Bank of Japan introduced its guidelines at the July meeting with a wider trading band for l0-year Japanese Government Bonds (JGB), the UBS economists pushed back their adjustment timeline to April 2019. The 10-year JGB real yields rose rapidly after the policy change and appear attractive at current levels as the UBS see inflation accelerating in the near term.
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