Pay USD 1Y1Y at 0.61% vs receive 2Y1Y at 1.49% in 2-to-1 BPV ratio.
Enter ½ position at 27.0bp (estimated roll-down 21.5bp over 12 months).
Keep a possibility of scaling into the next ½ position above 40bp.
Target at 0bp, stop at 50bp.
Position for higher money market rates in USD curve
The market assessment of the future Fed funds rate path is now considerably shallower than following the peak in rates late September. This partly follows the successful communication from the FOMC during the autumn, which effectively delinked the QE-tapering decision from the timing of future Fed fund hikes. During January the deteriorating risk sentiment and a bout of weaker US data pushed money market rates lower again. The market is now discounting a first Fed funds hike to 0.50% to take place in October or December 2015 and the Fed funds future for this month is trading close to prior lows.
We believe that the current softness in the US data is mostly weather related and therefore temporary in nature. We believe that most of the weakness has now been priced in the market and that there is now little room for lower rates in the 1y1y part of the USD swap curve.
Given the limited room for lower rates, paying this part of the curve offers both a reasonable tactical risk reward and a good protection towards a firmer US growth scenario. One drawback by paying 1y1y USD outright is, however, the measurable negative roll down of about 34bp over 12 months.
One way to circumvent this, is to receive half of the BPV risk in USD 2Y1Y against the USD 1Y1Y (i.e. the position is USD 2Y1Y – 2*USD 1Y1Y). The USD 2Y1Y is rolling 89bp over 12 months, so the combined roll down of paying double BPV in USD 1Y1Y versus receiving USD 2Y1Y is +21.5bp over 12 months.
The 2Y1Y versus 1Y1Y part of the curve is close to record steep and we believe that there would be limited room for further steepening in a scenario where Fed funds hike expectations have advanced materially. Further, note that the trade would still gain as long as the 2Y1Y versus 1Y1Y segment steepens less than 5bp for each 10bp move higher in the 1Y1Y rate.
Another advantage of this position is that it provides some protection against a negative economic outcome where rates move lower – partly because this would flatten the money market curve and partly because the position rolls positively by 21.5bp over the first 12 months.
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