Today, the FOMC will hold its monetary policy meeting. Market expectations point to a 50bp hike because some Committee members have shown the likelihood of such action as inflation remains under pressure and jobs continue to recover. After the 1Q22 GDP preliminary print showed a quarterly annualized contraction of 1.4% given higher imports and inventories, the strong performance of personal consumption fueled the current debate on whether persisting inflation has to do with the acceleration in demand, which in our view is not clear. For Banco de México, we expect a hike of 50bp next week because of recent inflation readings and FOMC actions. In the short term, Banxico will most likely keep a hawkish stance and will hardly decouple from the Fed. Therefore, short tenors will continue to price in more hikes. Nonetheless, we still expect the belly to remain more anchored as concerns regarding the economic outlook are weighing in long-term monetary policy expectations. In the next six months, the TIIE curve is already discounting a reference rate close to 8.50% and a terminal reference rate close to 10.00%. We do anticipate more hikes to come, but also believe that the central bank will slow the hiking pace to 25bp and see the benchmark rate close 8.50% by year-end. Still, in the near term, markets will most likely keep pricing in a more aggressive tightening cycle as uncertainty regarding the decision-making process prevails.
In terms of carry roll-down, considering a 6-month horizon, drip continues to be attractive at the short end of the TIIE curve, especially in the 9M and 1Y tenors (nearly 175bp on average) as markets are factoring in a more aggressive approach from the central bank. However, as mentioned in our previous radars, Banxico will most likely continue to tighten monetary conditions, which means that the short end upward adjustment could offset the attractive carry-roll down of short tenors. Meanwhile, swap spreads paused their upward trend, but spreads could adjust, as they tend to increase when Banxico tightens.
The TIIE curve has flattened between the short end and the belly, and it is now inverted in that section. Indeed, spreads are at minimums considering history since 2010. While the flattening has been too fast and aggressive, recently slopes have remained volatile. Nonetheless, the reasons for an inverted curve remain, so we would expect low slopes and an inverted curve in the short term. At the very short tenors (1Y-3Y section), spreads remain distorted as markets have moved to price in more hikes from Banxico. The curve distortions would probably prevail in the near term. Nevertheless, once the CB’s approach becomes clearer, spreads between the belly and the short end could probably increase while those at the very short end (1Y/2Y, 1Y/3Y) should fall in the medium-long term.
The drip cost of a flattening strategy is around 54bp between the short end (2Y) and the belly (10Y). In terms of forwards, the 2Y/10Y slope is pricing in an additional flattening of 26bp. We reiterate that, as a directional trade, we continue to anticipate lower slopes because activity risks will prevail, and Banxico is already immersed in a tightening cycle. Regarding butterflies, spreads at the short end (1Y-5Y) are at maximum levels, close to their 97th percentile on average. Flattening strategies are expensive in that section of the TIIE curve because of recent carry roll-down levels. Meanwhile, butterflies between the short end, the belly, and the long end are still negative, and their levels are actually at their lowest percentile. Again, distortions would probably remain in place, which limits the scope to undertake relative value strategies.
Finally, FRAs remain above spot levels in the short end of the curve, as from the 2Y-3Y to longer tenors the spot curve has moved more than FRAs. Spreads at the short end (from the 3M to the 1Y) continue to increase because forwards have moved more than spot rates. Therefore, receiving forward rates and paying spot rates continues to make sense in that section. In contrast, longer-term (5Y and 10Y) spread levels have been decreasing, and spreads are now in negative territory as the spot rate has moved more aggressively than what the forwards have are pricing in. Forwards are discounting lower levels at the belly of the curve in line with our view of low slopes.