USD Curve Is Close To Record Steep In 1Y Forwards

Receive 7Y versus pay 2Y, 1Y forward in USD3M swaps

Open ½ position at 193.5bp with the possibility of another ½ position at 210bp

Levels: target at 160bp, stop at 225bp, roll: +7bp in the first year.

USD curve is close to record steep in 1Y forwards
Over the past month, the USD swap curve has re-steepened and the steepness in many segments of the curve is now close to record levels. The recent steepening has been unusual in the sense that it has been driven by a counter-directional move in short and long end rates.

At the long end of the curve, rates have moved higher. Recent incoming data has been fairly good suggesting the negative impact of the government shutdown and debt-ceiling fight in the autumn has been smaller than feared. With non-farm payroll gains trending close to +200,000 over the past three to four months, the likelihood of an early Fed tapering has increased. We now believe the Federal Reserve will taper in December and that this is priced with a fairly high likelihood in the 10-year segment. Further, there has historically been limited scope for further increases in the 10-year rate in the year following a +100bp sell-off such as the one experienced in Q2 this year. Hence, we do not believe the risk-reward for an outright short in that segment is very attractive.

At the short end of the curve, money market rates have moved lower. The confirmation of Janet Yellen as the next Federal Reserve chairman has helped to solidify Fed communication about low rates for long. Moreover, the subsequent discussion about the possibility of the Fed lowering the unemployment threshold for future Fed funds hikes has anchored money market rates further.

The success of the Federal Reserve in disconnecting the outlook for QE tapering from the expectation of future rate hikes has left the USD record steep. We now believe that it offers good risk reward to position for a flatter curve.

If our forecast for a measurable reacceleration of US GDP growth going into next year proves right, we suspect the Federal Reserve could face a scenario similar to the Bank of England, where money market rates has been de-anchored. In such a scenario, we expect the 2Y rate in 1-year forward to move radically higher, which would lead to a flattening of the 2Y-7Y in one year forward. In contrast, should the US economy unexpectedly slow down, the curve should flatten from the long end, as QE tapering could be postponed.

We prefer to implement this view as a 2Y-7Y flattener with a one year forward start. First, the trade offers positive carry contrary to a short position in the money market, which is very expensive. Second, the level of the 2Y-7Y spread one year forward is historically wide and offers more protection than an outright position in the 5-10 year segment of the curve.

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