Receive 2Y, Pay 15Y swap (EUR6M) in 1Y forwards.
Entry: ½ position @ 170bp, Add: ½ position below 155bp, Stop @ 139bp.
Roll down: +1bp/6M, -5bp/year
Aggressive ECB and higher US rates to steepen the EUR curve
Over the past six months, the EUR swap curve has flattened considerably. The curve flattening has been driven by two major factors.
First, the ongoing decline in euro area inflation to a multi-year low of 0.5% and the following expectations of more ECB easing has pushed rates lower across the curve. With the short end limited by the zero bound, the lower rates have resulted in a flatter curve.
Second, the recent sharp decline in long US rates has spilled over to the EUR swap curve pulling long-end rates lower. The sharp move in the long end of the USD curve has most likely been driven by a combination of weak positioning (many investors have been short following last year’s sell-off), portfolio rebalancing flows (from equities into bonds) and a disappointment in US growth expectations early this year. We now believe that room for lower long US rates is relatively limited. Growth is once again picking up and positioning is starting to become more aligned. Moreover, the market has become more complacent regarding the Fed, with fed funds futures priced some 70bp below the Fed projections for 2016. With US inflation starting to pick up, we believe it will be harder for the Fed to argue for downside inflation risk. The risk of a US fixed income sell-off is now increasing and higher US rates would add steepening pressure on the EUR curve.
At the same time, the ECB is moving towards more aggressive easing measures to fight the deflation risks. We believe that the expected combination of rate cuts (negative deposit), a new LTRO (perhaps fixed rates) and potentially credit easing measures will have two major impacts on the EUR swap curve: the short end will be further anchored and the long-end forward will gradually start to move higher as inflation and growth expectations get a boost. Following the Fed’s QEIII, the curve steepened materially.
We therefore recommend to position for a steeper EUR curve via receiving 1Y2Y and payer 1Y15Y in swaps (EUR6M). If the ECB cuts to a negative deposit rate and launches a new LTRO there would still be a little room for Euribor contracts to rally. Furthermore, the 1Y2Y has a decent roll down of 11bp over six months.
For the paying leg, we prefer to position in tenors above 10 years, as the five-seven year segment could rally further in a scenario where the ECB signals QE.
This risk is lower in the longer segment of the curve, which also has a ‘cheaper’ roll down. Since its peak at around 197bp in November 2013, the 2-15 1Y forward flattened to a low of 164bp in late April. Since then, the curve spread has been relatively stable despite another leg down in rates. We believe this position offers good risk reward in a scenario of aggressive ECB easing and risk US rates.
To Read the Entire Report Please Click on the pdf File Below