Trade Recommendation: Receive 5Y EUR/USD Swap Spread

Receive 5Y USD swaps, 4Y forward (versus 3M Libor) versus pay 5Y EUR swaps, 4Y forward (versus 6M Euribor).

Open ½ position at 135bp with the possibility of another ½ position at 155bp.

Levels: target at 90bp, stop at 173bp, roll: +7bp in the first year.

Long-end EUR/USD spreads set to narrow from record levels
Following the move higher in interest rates in 2013, the US swap curve priced broadly at the long-end of the curve (10Y). Meanwhile, the long-end of the EUR curve is still too low in our view and will move higher during the course of 2014. This is consistent with our expectation of continued normalisation in the financial markets alongside the recovery in the eurozone becoming a more pronounced.

In 2014, we look for a steeper US money market curve, which should put the belly (5Y) at risk. In our view, this will lead to a bearish flattening of the 5Y/10Y swap slope from record-high levels. Meanwhile, we believe the ECB will be able to shield the belly of the EUR curve in 2014 and hence the 5Y/10Y slope of the EUR swap curve should steepen on a relative basis versus the US curve.

Implementation
An obvious way to us to express the view would be to receive the 5Y/10Y USD-EUR box. However, the valuation is not that attractive and there is a negative carry roll of 1bp per month. Rather, a screening of the swap market suggests it offers attractive risk-reward to receive the 5Y USD-EUR swap spread, 4Y forward. The spread is close to the all-time high and there is an expected positive roll-down of 7bp next year.

A simple model of the spread suggests a positive beta versus the outright US rate level. However, given the size of the spread, we could actually see the beta decline towards zero or even turn negative.

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