BofA Merrill Lynch is advising clients to buy Treasury securities.
“We recommend a tactical long on the [5-year] note to position for a [10 to 15 basis point] decline in rates over the coming weeks,” write BofA interest rate strategists Priya Misra and Shyam Rajan and technical strategist MacNeil Curry in a note to clients. “A combination of headline risks around the continuing resolution, dovish Fed speak, a possible Yellen nomination compounded by short positioning and technicals in the market could lead us lower in yields over the coming two weeks. Note that this is a tactical trade and we still maintain our view of rates heading higher by year end.”
The strategists initiated the trade at a 1.45% yield on the 5-year Treasury note, targeting 1.3%. (Right now, the 5-year yield is at 1.42%.)
Misra, Rajan, and Curry expand on the five drivers of the trade:
- Fiscal headlines. “We think the chances of a brief shutdown after September 30 has increased,” says the BofA team. “More importantly, the market sensitivity to fiscal headlines is likely to have increased given that the chairman explicitly mentioned the upcoming fiscal policy decisions — as a cause for concern.”
- Possible Yellen nomination. Misra, Rajan, and Curry think the nomination of Janet Yellen to replace Ben Bernanke in the top spot at the Federal Reserve is close. “Recall that in a speech last year, Yellen prescribed keeping the Fed funds rate close to zero until late 2015 and at about 2% by the end of 2016,” say the strategists. “This would be even more dovish that the SEP released this week.”
- Dovish Fed speak. BofA points to a speech by New York Fed president and influential FOMC member Bill Dudley, who on Monday said he voted not to taper because he didn’t see sustainable improvement in the labour market yet. “This continues to highlight the relatively high threshold (high when compared to what was previously thought) for the Fed to taper,” say Misra, Rajan, and Curry. “Speeches by Evans and Rosengren later this week are also likely to re-emphasise this point.”
- Short positioning. The latest survey and CFTC data showed a buildup in short positioning in Treasuries heading into last week (charts below). “The combination of the Summers withdrawal and the dovish FOMC is likely to have helped reduced some of this short base,” says BofA. “However, there may be some more short covering, as the market re-evaluates recent weak data that it has arguably ignored (as tapering for September was thought to be a done deal) in the context of a dovish Fed.”
- Technicals. BofA asserts that there is still momentum to the post-FOMC price action in Treasuries from a technical standpoint. “Treasuries have turned near term trend from bearish to bullish with 5yr yields set to continue lower in the sessions and weeks ahead,” say the strategists. “We look for a push towards the 1.273%/1.224% resistance zone, before renewed basing.”
Of course, there are risks that could derail the trade, as Misra, Rajan, and Curry admit.
“Stronger than expected data and relatively benign fiscal negotiations are risks to this trade,” they write. “However, the underpinning of a fragile recovery and a dovish Fed that is in no hurry to taper lead us to believe that the risks to a sharp rise in rates in the coming weeks is small.”
The charts below show short positioning indicators.