After the January FOMC statement, which revealed an unambiguously dovish Fed, the market has re-priced front end yields lower in anticipation of a Fed that remains on hold until "at least through late 2014"; 2014 December fed fund futures are trading at 0.57%, and 3y and 5y yields are now trading at 30bp and 70bp, respectively.

However, moving beyond the explicit mention of 2014 in the FOMC statement, we find other changes in the statement and Chairman Bernanke's comments in the subsequent press conference as revealing of the further easing steps that the Fed might take. These steps, likely in the form of further asset purchases, are not adequately being priced, in our view.

First, the FOMC statement stripped out previous wording that "the Committee will continue to pay close attention to the evolution of inflation and inflation expectations." This can be taken as a signal that, at least for now, the Fed is focused on the employment side of its mandate and that it will not be particularly focused on current movements in inflation or inflation expectations. Chairman Bernanke reiterated this accommodative view in his press conference by saying that "if inflation did go above target by a modest amount, we would certainly try to get it back down to target, but if unemployment were very high, that would lead us to be more cautious and slower in returning to target."

Second, Chairman Bernanke noted that "if the recovery continues to be modest and progress on unemployment very slow, and if inflation appears to be likely to be below target for a number of years out - so the configuration we're talking about in the projections - then I think there would a very strong case, based on our framework, for finding different additional tools for expansion." In other words, the Chairman believes that even if the Fed's own economic projections are realized, there would be a very strong case for additional easing.

When taken in the context of consensus expectations of the evolution of real GDP growth and the unemployment rate, which are more pessimistic than the FOMC's forecasts, the case for additional easing indeed appears quite strong. However, this does not seem fully reflected in the market, for a couple of reasons.

First, agency MBS-Treasury spreads are still quite wide given that additional asset purchases will most likely be in agency MBS. Second, the 10y sector on the Treasury curve is not trading as rich as it should in the context of the potential demand shock being mostly in the belly of the curve. Third, the 10s30s breakeven curve has steepened only marginally, in sharp contrast to what happened when QE2 was getting priced in.

Finally, 5y forward 5y breakevens have not risen as much as they should have, given easier monetary policy. The forward breakeven rate is actually lower than that just prior to the January FOMC statement. This stands in sharp contrast to the experience during the build-up of QE2 expectations, when the 5y forward 5y breakevens had increased from about 2% at the end of August 2010 to 2.9% in early November, when QE2 was announced.

We therefore recommend trades that would benefit from further pricing of additional asset purchases. Specifically, we believe the 10y sector should continue to richen versus 5s and 30s. Also, since TIPS breakevens beyond the 5y tenor have under-reacted to the Fed's announcement, we recommend a long position in 5y5y breakevens and 10s30s breakeven steepeners. A higher inflation risk premium should also support nominal 10s30s curve steepeners.


source: BarCap