By the Numbers

Navigating negative carry in longer durations

| June 9, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Excerpted from Santander CIB, Interest & Exchange, June 2, 2023, and edited for US Portfolio Strategy.

The Fed has come close to the end of its hiking cycle for now, but a deeply inverted curve means adding duration and receiving in longer rates comes with plenty of negative carry. Receiving in 1-year tenors strikes a good balance. Receiving in forward rates also looks reasonable. But with longer yields likely to head lower later in the year, adding some duration makes sense.

History favors steeper curves at the end of a Fed hiking cycle. The historical average period from the last Fed hike to the first cut is approximately six months. And Fed rhetoric already has started to include more centrist members calling for a pause. To best position for a rate cut, or at least hedge against it, receive in 1-year SOFR. At 5.09%, it offers a decent balance of risk and reward if there is no hike and protects against a bull shift in the market.

Further out the curve, and although not the most likely scenario or best overall position, payers in the belly look best especially for portfolios putting a lot of weight on near-term carry. Overall, however, it still looks better to receive in forward rates, particularly the 2- to 5-year part of the curve. The heavily inverted curve continues to generate positive carry on payers, with cumulative positive carry for payers on maturities of up to five years. Receivers work best as longer tenor hedges, where future rate cuts dominate the landscape. The recent move higher in yields favors portfolios looking to pay duration, notably in 2-year tenors.

Market rates have been moving in a broad range for months now yet essentially with a clear mean-reverting tendency as the markets shift between bouts of hawkishness and dovishness. This is especially so with the 5-year SOFR rate at 3.6%, some 165 bp below the funds rate ceiling.

Beyond the June FOMC and into the third quarter of this year, longer end yields should ultimately head lower as the impact of past hikes leans on growth. But sticky inflation also suggests that yields could remain higher for longer. Market rates lie well below their respective floating rate, implying that fixed-rate payers secure positive carry. This positive carry persists well into 2024, even as the Fed turns to cutting rates as the gap between the funds rate and market rate offers a considerable cushion.

Carry turns negative for payers by 2025, by which time the Fed will have possibly cut the funds rate back to 3% (ceiling). Still, the positive carry seen in the early years tends to outweigh the subsequent negative carry.

For swapping-to-floating strategies, large negative carry can be an issue. Future rate cuts clearly help this trade, and the deeper the cuts, the better. Ideally, though, market rates would be some 25bp higher before getting overly excited on receivers. The Fed’s outlook of “higher for longer” especially hinders receivers.

The US curve remains comfortably above the 15-year average, for all tenors, and right down to the fed funds rate. It is still below prior highs though, by some 100 bp to 200 bp in the belly of the curve, and by over 250 bp in ultra-long tenors. However, the funds rate is now flat compared to its former high. The current curve is remarkably inverted in consequence.

Cormac O'Connell
cormac.oconnell@grouposantander.com
coconnell

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