Asia Rates: Waiting for DM pivot
- DM hike cycles are being extended. The likelihood of resumption of rate hikes in Asia is low.
- Though Asia hike cycles have ended, Asia market rates could still be pulled higher by US/core.
- Asia rate cut pricings have materially unwound, both in terms of quantum and timing.
- Asia central banks could still tighten liquidity and push money market curves higher.
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Except for the Bank of Thailand where we see one more 25bps hike in 3Q, the rest of Asia ex China central banks are in pause mode, and we expect no further rate hikes for this cycle. Asia central banks will however maintain a hawkish tone, due to the perceived need to be vigilant around domestic inflation risks and to a lesser extent, possible negative impact of higher US/core rates. On inflation, barring a larger-than-expected El Nino impact on food prices, we expect Asia inflation expectations to remain well anchored and headline inflation to ease sustainably into target ranges in 2024. Therefore, despite the continued hawkish tone of regional central banks, the likelihood of a resumption of rate hikes in Asia should be low.
In contrast, DM hike cycles are being extended further out, and there is still some uncertainty on the eventual level and timing of terminal policy rates. Based on current market pricing, DM policy rates are expected to peak only in 4Q. In DM, there are also greater worries of inflation being sticky and staying above central banks' targets, which underpins the uncertainty around terminal policy rates.
When we compare the policy/growth/inflation outlook between DM and Asia ex China, it is clear to us that the Asia outlook is relatively more stable. And as a result, for 3Q, we expect Asia ex China swap rates and bond yields to be mostly driven by fluctuations in US/core rates.
There are a few of implications for our strategy on Asia ex China swap rates and bond yields.
One, even though Asia hike cycles are expected to have ended, Asia market rates could still be pulled higher by US/core rates. For regional rates markets more correlated to US rates, such as Korea and Singapore, we estimate a beta of 0.5-0.7. For the rest of Asia ex China rates markets, we estimate a beta of 0.2-0.4. Current levels of Asia swap rates are certainly looking high relative to our forecast for policy rate trajectories. That said, for Asia swap rates to correct lower towards our estimates of fair levels, it will likely require DM central banks to turn decidedly less hawkish and/or DM data to worsen considerably. Until we get more visibility on the timing of terminal policy rates in DM, we think that across-the-board receive or long duration positions in Asia would too simplistic.
Two, due to the rise in US/core rates, we have seen a large unwind in Asia rate cut pricings, both in terms of quantum and timing. Asia policy rates are now generally priced to be kept unchanged in 2H - Markets are expecting the extension of DM hike cycles to mean that Asia central banks would push back the timing of the next cut cycle, potentially to start in 1H of 2024. Markets have also reduced the priced quantum/depth of cuts for the next Asia cut cycle, likely due to the fading of downside growth risks in DM. With this shift in Asia rate cut pricing and considering our assumption that Asia rate hike cycles have ended, it could be good risk-reward to receive 6m6m or 12m6m swaps in selective Asia rates markets, to position for potentially larger rate cuts in 1H or 2H of 2024.
Three, Asia central banks could still tighten liquidity and push money market curves higher, representing de-facto rate hikes. The intention behind this could be to improve short rate differentials relative to DM, as well as to show a hawkish stance to keep rate cut expectations at bay. Certainly, there is a limit to how much Asia central banks can raise money market curves - Overnight/short-term call/repo rates would ultimately be capped by the upper bound of policy rate corridors.
To highlight a couple of examples on liquidity tightening. In India, RBI has been conducting a higher frequency of 2D to 4D VRRR auctions where they absorb excess liquidity in larger amounts and at higher rates relative to SDF - With system liquidity in a comfortable surplus, RBI seems to want to prevent overnight call rates from staying in the lower half of LAF corridor. In Korea, BOK has net issued a significant amount of MSBs since 2Q which has tightened liquidity and led to 3M MSB yields rising relative to the policy rate.
Asia Rates – Our stance and ideas
We make the following adjustments to our list of Asia Rates Ideas.
- CNY Rates - Initiate Pay 5Y CNY NDIRS
After the recent cuts to deposit and policy rates, there are expectations for policymakers to follow up by announcing fiscal stimulus and support measures for the property sector. This is especially as economic activity has continued to slow and sentiments remain bearish on the growth outlook. Our China Economics team had also recently downgraded their 2023 GDP forecast to 5.0%, from the previous 5.5%.
To mitigate the risk of missing the official 5.0% growth target, we think there will be announcements of stimulus/support measures to come. But those measures are likely to be gradual and targeted, due to constraints on local government finances and worries of encouraging property speculation. Market expectations appear to be in line with ours - The consensus seems to be for modest stimulus/support measures and the resulting growth impact to be limited.
If expectations of stimulus/support measures are already quite low, we think it could be good risk-reward to pay CNY rates to position for a possible upside surprise. Technical considerations are also supportive of such a play - Current 5Y CNY IRS levels of 2.40-2.45% are low relative to historical, and as we have seen several times in 2022, 5Y rates tend to bounce off from these depressed levels. We see possible 5-15bps of upside in the event of a moderate upside surprise to the size of stimulus/support measures.
- INR Rates - Exit 1Y-5Y INR NDOIS Steepener, Initiate Pay 5Y INR NDOIS
Largely due to favorable base effects, India's YoY headline inflation prints were relatively benign in 2Q. Compared to prior quarters, inflation worries were consequently lower in 2Q and did not put any visible upward pressures on INR OIS rates. However, that could change in 3Q as base effects fade and food prices get more volatile on the back of weather-related disruptions. Our India Economist is forecasting headline inflation to climb to 5.8-6.0% in 3Q, a sharp rise from the 4.6% monthly average in 2Q.
Our base case view is that RBI would see the 3Q increase in inflation as temporary and would not resume rate hikes in response. Markets seem to agree as well, as RBI policy rates are currently priced to stay unchanged in 2H. That said, considering that there are some risks of inflation breaching the 6% upper bound of target range, the risks are likely skewed towards short-term surges in OIS rates as and when hike expectations build. Therefore, we expect OIS curve to be biased to bear-flatten in 3Q, and are thus, exiting our existing 1Y-5Y INR NDOIS Steepener idea.
We would like to pay some NDOIS rates to position for the above-described short-term surges that are likely in 3Q. In terms of tenor, we prefer to pay the 5Y, as the 5Y could also see disproportionally larger paying pressures from the continued heavy GSec/SDL bond supply and its associated hedging flows. 5Y NDOIS rate has in recent days pulled back to 6.24% from a local-high of 6.44%. We think this pullback provides a good entry level to pay, with limited downside risks (6.00% would be a strong resistance level).
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