Interest Rate Derivatives Waiting Game-110516246

1Srini Ramaswamy AC (1-415) 315-8117srini.ramaswamy@jpmorgan.comJ.P. Morgan Securities LLCIpek Ozil (1-212) 834-2305ipek.ozil@jpmorgan.comJ.P. Morgan Securities LLCPhilip Michaelides (1-212) 834-2096philip.michaelides@jpmchase.comJ.P. Morgan Securities LLCArjun Parikh (1-212) 834-4436arjun.parikh@jpmchase.comJ.P. Morgan Securities LLCNorth America Fixed Income Strategy27 September 2024J P M O R G A N•Near term Fed expectations remain where they were a week ago as markets await next week’s employment report, but the broader swap curve steepened again this week as yields rose at the back end. This apparent shift in swap yield curves’ expo-sure to front end Fed expectations is actually merely the result of the fact that multi-ple factors are at play. All four market factors in our yield curve models have seen significant variation in recent weeks, and collectively explain curve moves quite well•Of particular note, the volatility of long run 5Yx5Y inflation expectations has recently been higher, making it an important second factor driving yield curves and longer maturity yields. Indeed, an unbundling of realized volatility into components stemming from each principal component suggests that realized volatility attribut-able to the second principal component (or PC2 vol) has been drifting higher, in step with the rise in the volatility of long term inflation expectations. At the same time, however, implied PC2 volatility has declined sharply, making it attractive to create long exposure to volatility of the second principal component. There are currently three attractive ways to do this … •… sell 6Mx10Y swaption volatility versus buying 130% of the vega risk in 6Mx30Y swaption straddles …•… overweight 6Mx2Y swaption volatility versus 6Mx5Y swaption volatility … •… and overweight 5s/30s curve volatility via YCSOs versus a carefully weighted short in 6Mx5Y swaption volatility•Funding conditions continue to tighten, T-bill supply is poised to turn positive for the next two months, and high grade corporate issuance and related swapping activi-ty could pick up as we move towards mid-October. All of these will likely pressure spreads narrower, but there are important offsets. Asset-swapping front end USTs offers a significant pickup over IOR relative to OCI risk for banks, and such a receive-SOFR position is also an attractive way to position for a rise in SOFR and/or a curative cut in IOR if indeed repo rates drift much higher•The attractiveness of front end asset swaps to banks is thus an important offset, as are cheap valuations, and we therefore remain neutral on swap spreads for now on an outright basis...•... the exception to this view is the 7-year sector, where we recommend initiating narrowers as 7-year spreads appear noticeably wide to fair value •On a relative basis, position for a steeper 7s/10s swap spread curve due to its asym-metric exposure to 7s/10s UST yield curve flattening as well favorable entry levels. In addition, 2s/3s swap spread c