Steeper EUR Curve vs Flatter US Curves
One of our core views for 2014 is that the EUR curve should steepen from the long end. We base this view on the expectation of continued macro improvement and on an expectation that the ECB will eventually do more to lift long-term inflation expectations. We have positioned for this view through 15Y15Y payer spread in EUR swaptions (see Trade Recommendation: Enter 15Y15Y EUR payer swaption spread, 13 December 2013). We like the trade for the strategic horizon as a hedge against higher rates, while still benefiting from a positive roll-down from the swap and VOL curves.
We believe the short end in EUR is more solidly anchored due to the ECB easing bias, leaving room for a steeper 5/10 EUR slope. We have implemented this view against the USD to benefit from the stretched level of the relative curves. The recommendation is to receive the 5Y EUR-USD swap spread 4Y forward, as this variant had better properties relatively to the 5/10 USD-EUR box (see Trade Recommendation: Receive 5Y USD/EUR swap spread, 4Y forward, 23 December 2013). So far, this position has faced some headwinds but we still like it and would rather scale further in than stepping out, as we see only moderate upside risks to US rates in coming months. First, it seems positioning is already for higher rates and, second, it appears that expectations for the weather rebound are high. Meanwhile, in Europe rates are at the low end of the ranges and we see limited downside as inflation is troughing.
Another way of fading the recent uptick in the belly of the US curve (5Y segment) is to receive the belly of the 2/5/10 US fly versus paying the belly in the similar EUR fly, which was opened last week (see Trade Recommendation: Receive belly in 2/5/10 fly (3M fwd) in USD swaps vs EUR, 1 April). In the case of the expected weather rebound being shorter and weaker than generally anticipated by the markets and the Fed, there is plenty of potential for performance. On the other hand, if the US sell-off continues, we see limited risks of further widening of the relative flies given the stretched valuation.
Add risk to receiver leg in US money market flattener trade
In mid-February, we saw value in paying 1Y1Y USD swaps as we believed rates had fallen too much in early 2014. One drawback of this strategy was the measurable negative roll down. A way to circumvent the roll structure was to receive half the BPV risk in USD 2Y1Y against the 1Y1Y (see Trade Recommendation:
Pay USD 1Y1Y vs receive 2Y1Y in 2- to-1 BPV ratio, 11 February). Thereby, we created a proxy flattener trade with attractive valuation and a positive expected roll down. Another feature was a partial hedge against a negative economic outlook where rates would move lower. Since opening, rates have indeed moved higher but the trade has not performed as the Fed has managed to anchor expectations about the timing of the first hike. This has tweaked the forward curves in such a way that the position has suffered from a worsened roll-down. To reduce these headwinds while still keeping the trade open, we add some risk to 2Y1Y receiver such that the BPV ratio is now 1.5:2 rather than 1:2 earlier. Relative to the original trade, this makes it slightly more directional, but with better roll-down. Another alternative would be to add risk in the 2Y1Y receiver such that the BPV ratio would be 1:1, which would add more roll-down and make it even more directional. See charts overleaf.
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Steeper EUR curve vs flatter US curves are the main themes
One of our core views for 2014 is that the EUR curve should steepen from the long end.
We base this view on the expectation of continued macro improvement and on an
expectation that the ECB will eventually do more to lift long-term inflation expectations.
We have positioned for this view through 15Y15Y payer spread in EUR swaptions
(see Trade Recommendation: Enter 15Y15Y EUR payer swaption spread, 13 December
2013). We like the trade for the strategic horizon as a hedge against higher rates, while
still benefiting from a positive roll-down from the swap and VOL curves.
We believe the short end in EUR is more solidly anchored due to the ECB easing bias,
leaving room for a steeper 5/10 EUR slope. We have implemented this view against the USD
to benefit from the stretched level of the relative curves. The recommendation is to receive
the 5Y EUR-USD swap spread 4Y forward, as this variant had better properties relatively
to the 5/10 USD-EUR box (see Trade Recommendation: Receive 5Y USD/EUR swap spread,
4Y forward, 23 December 2013). So far, this position has faced some headwinds but we still
like it and would rather scale further in than stepping out, as we see only moderate upside
risks to US rates in coming months. First, it seems positioning is already for higher rates and,
second, it appears that expectations for the weather rebound are high. Meanwhile, in Europe
rates are at the low end of the ranges and we see limited downside as inflation is troughing.
Another way of fading the recent uptick in the belly of the US curve (5Y segment) is to
receive the belly of the 2/5/10 US fly versus paying the belly in the similar EUR fly,
which was opened last week (see Trade Recommendation: Receive belly in 2/5/10 fly (3M
fwd) in USD swaps vs EUR, 1 April). In the case of the expected weather rebound being
shorter and weaker than generally anticipated by the markets and the Fed, there is plenty
of potential for performance. On the other hand, if the US sell-off continues, we see
limited risks of further widening of the relative flies given the stretched valuation.
Add risk to receiver leg in US money market flattener trade
In mid-February, we saw value in paying 1Y1Y USD swaps as we believed rates had fallen
too much in early 2014. One drawback of this strategy was the measurable negative roll
down. A way to circumvent the roll structure was to receive half the BPV risk in USD
2Y1Y against the 1Y1Y (see Trade Recommendation: Pay USD 1Y1Y vs receive 2Y1Y in 2-
to-1 BPV ratio, 11 February). Thereby, we created a proxy flattener trade with attractive
valuation and a positive expected roll down. Another feature was a partial hedge against a
negative economic outlook where rates would move lower. Since opening, rates have indeed
moved higher but the trade has not performed as the Fed has managed to anchor expectations
about the timing of the first hike. This has tweaked the forward curves in such a way that the
position has suffered from a worsened roll-down. To reduce these headwinds while still
keeping the trade open, we add some risk to 2Y1Y receiver such that the BPV ratio is now
1.5:2 rather than 1:2 earlier. Relative to the original trade, this makes it slightly more
directional, but with better roll-down. Another alternative would be to add risk in the 2Y1Y
receiver such that the BPV ratio would be 1:1, which would add more roll-down and make it
even more directional. See charts overleaf.