JPMorgan Econ FI-Interest Rate Derivatives False Fall-109990091

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Srini Ramaswamy

(1-415) 315-8117

srini.ramaswamy@jpmorgan.com

J.P. Morgan Securities LLC

Ipek Ozil (1-212) 834-2305

ipek.ozil@jpmorgan.com

J.P. Morgan Securities LLC

Philip Michaelides (1-212) 834-2096

philip.michaelides@jpmchase.com

J.P. Morgan Securities LLC

Arjun Parikh (1-212) 834-4436

arjun.parikh@jpmchase.com

J.P. Morgan Securities LLC

North America Fixed Income

Strategy

23 August 2024

JPMORGAN

•The commencing of rate cuts next month is all but certain, but there is considerable

uncertainty around pace. Uncertainty surrounding pace is apparent in option-implied

probability distributions, and supported by the tone of recent Fed-speak. Such uncer-

tainty is likely to amplify the sensitivity of yield levels to Fed-speak and/or economic

data, making it a key support for jump risk and elevated realized volatility, and is signifi-

cant enough to warrant a bullish stance on short-expiry swaption volatility despite seem-

ingly rich valuations, in our view

•SOFR and GC rates are normalizing, but front end spreads remain far too narrow.

Beyond valuations, one near term catalyst for a correction is likely to come in early

September as T-bill net issuance turns negative

•Term funding premium remains narrow relative to fair value, and thus appears biased

higher in the near term (due to a correction) as well as the longer term (due to a falling

share of price-insensitive UST buyers and eventually higher duration supply). Together

with the cheapness of zero-duration spreads, this argues for a flatter spread curve - posi-

tion for a flatter 5s/30s maturity matched swap spread curve

•Adjusted for the broader term structure, swap spreads appear too wide in the 7-year

sector and too narrow in the 20-year sector - initiate 7s/20s swap spread curve steepening

exposure, weighted to hedge exposure to rising term funding premium

•We examine the near term and medium Fed expectations that are currently being priced

into the swap yield curve. Currently, yield curves anchored in the front end, such as the

2s/5s curve, are fully priced to our Funds rate forecast, while forward OIS rates them-

selves appear high. This suggests that on a relative basis, outright longs at the front end

are preferable to front end curve steepeners

•In contrast, the Fronts/Reds curve does indeed appear fairly priced to our Fed funds

forecast, but forward swap curves and back-end spot curves are too flat and therefore

underpricing medium term fed expectations. This makes steepeners in these sectors

preferable to outright longs in the Reds and/or Fronts/Reds flatteners on a comparative

basis

False Fall

New Yorkers are accustomed to many additional seasons on the calendar, one of which is

colloquially referred to as "False Fall". Not quite Fall, and not quite Summer, it is a cuspy

time when the temperature seems to fluctuate between the two. The US Rates markets

appear to be experiencing their own False Fall, with front end yields falling initially, bounc-

ing higher on Thursday and then back lower on Friday. All in all, forward OIS as of mid-2025

traded this week in a ~20bp range and 2- to 5-year yields traded in a ~15bp range, before

finishing near the low end of the range (Figure 1).

Interest Rate Derivatives

False Fall

Srini Ramaswamy

(1-415) 315-8117

srini.ramaswamy@jpmorgan.com

J.P. Morgan Securities LLC

Ipek Ozil (1-212) 834-2305

ipek.ozil@jpmorgan.com

J.P. Morgan Securities LLC

Philip Michaelides (1-212) 834-2096

philip.michaelides@jpmchase.com

J.P. Morgan Securities LLC

Arjun Parikh (1-212) 834-4436

arjun.parikh@jpmchase.com

J.P. Morgan Securities LLC

North America Fixed Income

Strategy

Interest Rate Derivatives

23 August 2024

JPMORGAN

Figure 1: Swap yields were lower this week on the back of weaker data and a dovish tilt in the FOMC

minutes

Selected statistics for SOFR swap yields, YE24 OIS, and 1H25 OIS, 8/16/2024 - 8/23/2024; %

Start Change End Min Mean Max Range

2Y 3.87 -0.17 3.70 3.70 3.79 3.87 0.17

3Y 3.65 -0.16 3.49 3.49 3.57 3.65 0.16

5Y 3.48 -0.13 3.35 3.34 3.41 3.48 0.13

7Y 3.44 -0.11 3.33 3.32 3.38 3.44 0.12

10Y 3.45 -0.08 3.37 3.34 3.39 3.45 0.11

20Y 3.50 -0.06 3.44 3.39 3.45 3.50 0.10

30Y 3.35 -0.04 3.30 3.25 3.30 3.35 0.10

YE24 OIS 4.38 -0.09 4.29 4.28 4.34 4.39 0.12

1H25 OIS 3.58 -0.18 3.40 3.39 3.49 3.58 0.18

Source: J.P. Morgan.

The catalysts for the decline in yields were many - weak Canadian CPI helped spark the

initial move lower, but there were other factors as well. Benchmark revisions to the estab-

lishment survey were weaker (-818K) than our expectations (-360K), the FOMC minutes

were more dovish than expected especially considering that the meeting took place before

the last employment report, and Fed Chair Powell's comments were quite dovish on Friday.

But this week was also a reminder of the significant policy uncertainty that continues to

permeate the market. As of this writing, markets are pricing in about 100bp of easing by year

end. But although there is consensus among Fed speakers that policy is restrictive and easing

is now appropriate, there is not yet an obvious consensus on pace. As seen in Figure 2,

several speakers appear to be leaning against expectations for 50bp cuts. In other words, the

pace of cuts remains undecided, and options markets reflect that. Our favorite metric for

policy uncertainty is based on inferring an implied probability distribution from the prices

of calls and puts on Z4 (and/or M5) SOFR futures, and then de-constructing those implied

distributions into "weights" associated with each policy outcome. Since the weights must

sum to one by design, this provides an intuitive way to "read" the information in the tails

of the distribution. The point of this exercise is to see if the forwards (which represent an

average across outcomes) are averaging across a relatively narrow (indicating policy clari-

ty) or a relatively wide (indicating policy uncertainty) range of policy scenarios. As we can

see, the weights on deep cut scenarios are reasonably comparable to the weights on

shallow cut scenarios, which suggests that dispersion remains wide and there is more

uncertainty around outcomes even at a horizon that is only four months into the future

(Figure 3).

Srini Ramaswamy

(1-415) 315-8117

srini.ramaswamy@jpmorgan.com

J.P. Morgan Securities LLC

Ipek Ozil (1-212) 834-2305

ipek.ozil@jpmorgan.com

J.P. Morgan Securities LLC

Philip Michaelides (1-212) 834-2096

philip.michaelides@jpmchase.com

J.P. Morgan Securities LLC

Arjun Parikh (1-212) 834-4436

arjun.parikh@jpmchase.com

J.P. Morgan Securities LLC

North America Fixed Income

Strategy

23 August 2024

JPMORGAN

Figure 2: Several Fed speakers appear to be leaning against expecting

more aggressive rate cuts

Selected Fed-speak excerpts, 8/22/2024 - 8/23/2024

Date Fed Speakers Comments

8/23/2024 Powell, v

‘The Time Has Come’ for Interest Rate Cuts,Current rate level gives ample room to respond to risks, Timing, pace of cuts to

depend on data, outlook, risks, Inflation risks have diminished, labor risks increased

8/23/2024 Mester, nv

Current data don’t make the case for a larger, 50-basis-point cut, Whether the Fed cuts by 25 or 50 basis points is not the

biggest issue for them, The pace and the magnitude of the easing cycle are going to depend on how the economy evolves,

Starting with a 50 basis point cut could mean markets then expect even more easing going forward, Being steady, thinking

about what the right pace is geared to how the economy is working and evolving is the right way to go

8/23/2024 Bostic, v

Next step on rates depends on the next data points, Payroll revision didn't really change jobs view much, Inflation came

down more than expected, May make sense to pull forward my view on rate cuts, Inflation dashboard is 'still flashing red',

Inflation 'is not particularly close' to Fed target

8/22/2024 Collins, nv

Data gives me more confidence that we're on path to 2% inflation, Labor market is `healthy,' want to preserve it, See

recalibrating policy at “a gradual, methodical pace”

8/22/2024 Harker, nv

Need to start process of lowering rates in September, Latest jobs report bit lower than expected, not a lot, See 'high level' job-

market softening, On board with September cut if data is as expected, Slow, methodical approach to cuts is way to go

8/22/2024 Schmid, nv

Need to see more data before supporting rate cut

Source: J.P. Morgan., Bloomberg Finance L.P.

Figure 3: Policy uncertainty remains elevated, even at a horizon that is only

four months into the future

Total weights on year-end policy rate scenarios representing 1 hike, Shallow Cuts*, and

Deep Cuts*, as calculated from a decomposition of the implied probability distribution

associated with Dec 2024 SOFR futures**; Feb 2024 – Current

0.0

0.2

0.4

0.6

0.8

1.0

Feb 24 Mar 24 Apr 24 May 24 May 24 Jun 24 Jul 24

1 Hike

Shallow Cuts

Deep Cuts

Source: J.P. Morgan., CME

* Shallow Cuts correspond to the total weights on the 0 Cut,1 Cut, 2 Cuts, and 3 Cuts scenarios. Deep

Cuts correspond to the total weights on the >3 Cuts scenarios. Scenarios outlined in Figure 2 of What’s

the rush?.

** We enumerate a list of scenario-specific Normal distributions with fixed standard deviations and

means that are separated by 25bp, and then require the implied distribution to be a weighted combina-

tion of these individual distributions. The weights are then solved for, by fitting to the observed prices

of calls and puts at various different strikes. For more details of our approach, see What’s the rush?

Therefore, it appears likely that policy uncertainty will continue to haunt markets until at

least next Payrolls, which will be critical in anchoring expectations. Despite the near cer-

tainty of a cut in September, the pace and extent of easing remain uncertain, which likely

means that yields will be highly sensitive to new economic or policy information that arises

in coming weeks. Indeed, the evidence supports the notion that yields are much more

sensitive to Fed-speak in periods of significant policy uncertainty. To see this, we turn

to our long-standing "Fed-speak Index", which is constructed by (i) manually identifying

key Fed-speak events, and (ii) recording the 15-minute change in 5Y UST yields following

the start of the speech, and then (iii) accumulating this change in a cumulative index. This

index is designed to convey a sense of direction - i.e., is Fed-speak leaning dovish or hawk-

ish. But we can examine the magnitude of changes in this cumulative index on days where

there was a Fed-speak event, grouped by periods of policy clarity versus policy uncertainty

over the past six months. We do this in Figure 4, where we show percentile moves in each

type of period. For instance, 90% of Fed-speak events produced a change of ~2.8bp or less

in periods of policy clarity, but during periods of policy uncertainty the moves were larger

and the 90th percentile move is over 5bp. In other words, the current backdrop of policy

uncertainty will likely serve to amplify the effect of new information, whether from Fed-

speak or from economic data.

We see such a backdrop as conducive to jump risk and supportive of elevated realized

volatility in rates. This is quite evident when we look at a decomposition of month-to-date

delta hedged returns from long straddle positions in various sectors. As seen in Figure 5,

long volatility positions were not just profitable overall, but the portion attributable to deliv-

ered volatility (i.e., gamma P/L net of theta) was a significant fraction of the overall return.

Thus, policy uncertainty has very tangible consequences and will likely continue to be sup-

portive of a bullish view on volatility. Of course, one must always consider whether current

valuations are rich enough to offset the above mentioned supportive factors. In this regard,

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1SriniRamaswamyAC(1-415)315-8117srini.ramaswamy@jpmorgan.comJ.P.MorganSecuritiesLLCIpekOzil(1-212)834-2305ipek.ozil@jpmorgan.comJ.P.MorganSecuritiesLLCPhilipMichaelides(1-212)834-2096philip.michaelides@jpmchase.comJ.P.MorganSecuritiesLLCArjunParikh(1-212)834-4436arjun.parikh@jpmchase.comJ.P.MorganSe...

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