On Tuesday, sovereign bonds remained in demand following the risk-on sentiment in the FX markets. Thus, the sovereign yield curve moved down 8-10bp and RFLB 28 closed at 9.55%, meaning that the move in yields after the CBR’s decision was quite close to the 50bp increase along the curve. Meanwhile, the CBR released data about the holders’ structure in the sovereign bond market. Foreign participation was 25% of the market volume in 3-5-year notes, 30% in the 5-7-year segment, 40% in the 7-10-year segment and about 15% in 10-15-year tenors. Thus, the data highlights that the foreign investor participation shifted towards shorter tenors.
Over the last few days, the OFZ curve has flattened markedly, with the 2s10s spread tightening 35bp to 75bp. The price action was driven by Friday's rate hike and continued political volatility, in our view. However, we draw attention to the flattening between the belly and longer-dated bonds; in particular, the 5s15s spread now stands at only 20-25bp, close to the lows since 2012. In particular, RFLB 19s now trade at a yield of 9.25%, while RFLB 28 is seen at 9.55% and RFLB 23s at 9.40-9.45%. In our view, there is very limited room for a further flattening between the belly and the long end of the OFZ curve. Therefore, we recommend buying bonds on the belly (i.e. RFLB 18-19s) against selling long end (DV01 neutral). Alternatively, selling long futures for OFZ basket looks appropriate as well, but one needs to consider the liquidity limitations here. In our view, the proposed trade is neutral to FX volatility (to a certain extent, of course). Moreover, we think swings in the FX market would likely produce more pressure on the longer end of the OFZ curve, unless there is strong and persistent pressure on RUB.
The key risk for the steepener is the outlook for the CBR's monetary policy, as the flat curve shape could be justified by expectations of rate hikes in the not so distant future with some easing afterwards. The central bank has guided for no rate cuts over the coming months – although we do not think rate hikes will be on the agenda either unless there is severe pressure on the rouble. We believe the rationale behind sending this strong message was primarily driven by credibility considerations, although we doubt the CBR’s credibility was in any way questioned after its bold move in March. Now the message has been sent (for a more detailed view on the CBR, see our CBR Monetary Policy Decision - Sledge-hammer credibility?, of 25 April). On the other hand, potential easing is subject to inflation performance (quite stubborn right now) and how strong the disinflation push is in 2H14. Moreover, we think potential monetary tightening in the US in 2015 could undermine the CBR's desire to cut rates. Additionally, the lack of new supply from the Ministry of Finance in the near term could provide some support to the long end, but in 2H14 we think MinFin will still increase the borrowings as debt redemptions start. However, all in all, we do not believe that the OFZ curve could turn inverted, which limits the downside to the trade (for a full version with charts please have a look at Trade idea – OFZ steepener looks interesting).