Limited Room To Trade The JUN14 FRA Yield Higher

Open position @ +38bp. Potential target @ +52bp, stop @ +28bp. Roll down (3M) -2bp.

Front end rates have moved significantly higher over the past week. However, we still think there is a fair chance that the Riksbank will cut in July. Whether it delivers or not in July, we think it is unlikely that the central bank will hike rates before next summer. The current pricing in JUN14 implies an unchanged repo rate next summer from 1% today. So going higher from here, more or less, means assigning probability for rate hikes over the coming year. At some point the market could, of course, do this if things improve quickly but prior to that we expect longer FRA yields to trade higher. Beyond the JUN14 contract, there is more room to discount rate hikes if the economy improves. For the moment, some 36bp is implied in hikes between mid-2014 and mid-2015.

The surge in short end rates has all of a sudden sent implied repo rates in the JUN14 contract slightly higher than what the Riksbank’s repo rate path implies. Further out on the curve, the Riksbank assigns much faster rate hikes, starting in the autumn of 2014. So, the JUN14 contract looks attractive to sell (rec) against JUN15 in the Riksbank scenario. In essence, we think the shortest – up to 1Y – money market rates have moved too much relative to the longer ones - beyond 1Y.

So despite the recent steepening we think the trade offers good risk/reward, given how the market has pushed 1Y rates up relative to longer ones. We especially like the trade where we put more risk in the front contract, i.e. to be receivers in the JUN14 contract and to be payers in the JUN15 contract as ‘hedge’ for a general decline in rates. For the moment we recommend double sizing in the front contract.

Risks and alternative trades
The trade should perform if rates continue to go up, or if the Riksbank cuts and/or the market expects it to cut. The risk in this trade is a general decline in interest rates, which will probably influence longer FRA rates the most. However, given the rise in short end yields, such a move will be less costly compared with a few weeks ago. An alternative is to receive outright in the FRAJUN14 contract. We favour combining the trade with 2s10s swap or bond curve flatteners or by attaching somewhat more risk in the front leg of the spread. For investors concerned about the ECB adding, or just hinting, anything about more liquidity, one might consider the box against EUR/IBOR contracts. The Swedish FRA curve has flattened in relative terms over the past month.

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