After Banco de México’s latest monetary policy meeting and September’s inflation data, markets continued to price in more hikes from the central bank. Markets are factoring in a benchmark rate above 5.00% by year-end, and in the following 12 months, the TIIE curve is pricing in a benchmark rate close to 6.60%. In our view, there is room for more than one hike during the rest of the year (see our note “Banxico’s hawkish stance prevails with an additional vote,” 23 September 2021). Nonetheless, for 2022, markets are pricing in a more aggressive approach than our base scenario, as we believe the central bank will pause at end-2021 until the FOMC changes its stance and continues the cycle. Therefore, the current price action is opening the door to tactical positions at the short end of the nominal curve.
First, in terms of carry roll-down, considering a 6-month horizon, drip is very attractive at the short end of the curve, especially in the 9M-2Y section, remaining above 50bp. Indeed, in the 1Y-2Y section, drip is close to 80pb on average, and markets are already factoring in a more aggressive approach than our base scenario. Therefore, we recommend receiving 1Y and 2Y TIIEs as markets’ hawkish stance in that tenor could ease.
In terms of slopes, the 1Y/2Y slope spread is close to its 95th percentile (with history since 2010) as the curve remains distorted at the very short end. However, since markets are already pricing in a restrictive cycle from Banxico and the spread is too high, we continue to recommend the 1Y/2Y flattener. In the rest of the curve, spreads are close to their 40th percentile, lacking value to start a relative-value strategy. Regarding butterflies, spreads at the short end (1Y-7Y) are at maximum levels, close to their percentile 98th on average. Flattening strategies cost 2bp on average in that section, which makes the trade cheap, which is why we continue to recommend flatteners at the 1/2/3 butterfly.
Swap spreads at the very short end of the curve (from the 3M to the 1Y section) continue to be at minimums, close to their 5th percentile on average considering history since 2010. As mentioned in our previous radars, foreign appetite for TIIEs has increased in recent years, and as the short end is where foreigners can make a monetary policy bets, the distortion would probably remain. Nonetheless, swap spreads in the rest of the curve have been increasing. Indeed, spreads from the 2Y to the 5Y section are now close to their 45th percentile on average. As we stated in our previous radar (“TIIE Radar: Spreads offer tactical opportunities”, 10 September 2021), swap spreads tend to increase when Banxico tightens conditions as it has been the case in the latest weeks. We continue to anticipate an additional correction in short swap spreads, as the ongoing restrictive cycle will continue.
The drip cost of a flattening strategy is around 45bp between the short end (2Y) and the belly (10Y) as the curve has flattened in recent weeks. As we mentioned in our previous reports, we believe that there is still room for a relief rally in nominal rates, particularly at the short end of the curve. As a long term trade, we continue to anticipate lower slopes because activity risks will prevail and the CB is already immersed in a tightening cycle. However, for the time being flatteners are not attractive, in our view.
In terms of forwards, the market is factoring in an additional flattening of nearly 30bp at the 6M forward slope between the 2Y and 10Y, in line with our directional view. On the other hand, the 6M forward slope between the 2Y and 5Y is also pricing in a flattening of nearly 20bp. The recent price action of short-end forwards shifted to incorporate an additional flattening as forwards with longer duration increased to a lesser extent.
FRAs remain above spot levels in all of the curve, while spreads at the short end (from the 3M to the 1Y) have increased in the latest weeks as forwards have moved to a greater extent than spot rates. Therefore, receiving forward rates and paying spot rates continues to make sense in that section of the curve. In the 5Y (3Y/2Y) and 10Y (5Y/5Y vs. 10Y), spreads have recently decreased to 55bp and 54bp, respectively, and as the 5Y spot rate increased more than the forward rate, that section of the curve remains distorted compared to the belly.