By the Numbers
Navigating negative carry in longer durations
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. This material does not constitute research.
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.
This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.
Important Disclaimers
Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.
In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.
The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.
In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.
Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.
