Buy the June 14/15/16 euro (short belly) at -55.5bp (BGG: BEDM4M6 Comdty)
Scale in: ½ position at-55.5bp and the possibility of another ½ position at -70bp
Levels: Target at -15bp, Stop at-85bp, roll: Initial 3M +2bp, next 3M is +8bp
Position for higher rates, without negative roll-down
The US money market curve flattened in recent weeks on the back of renewed dovishness from the Fed, more mixed data and higher political uncertainty. The forward curve now discounts a first Fed hike (up to 0.50%) by Q3 15. Less than one month ago the markets saw a first rate hike by the end of 2014 (at that time the fly was at -34bp). The flattening of the money market curve has richened the belly of the June 14/15/16 euro fly to stretched levels and we see attractive risk/reward in going against this move.
Eventually we expect the debt ceiling to be raised and the political risk premia to decline again. In this scenario we expect rates to edge higher again and the position should perform, since the fly is positively correlated with the outright level of rates .
In a risk scenario, where the debt ceiling is not raised and the gridlock continues and this pushes rates significantly lower, the position could still exhibit positive performance, as the correlations could shift signs. This was seen in late 2011 and in 2012, when financial stress was also at high levels (see charts on page 2) and money market curves collapsed far out the curve.
The position offers attractive valuation, a bias towards higher rates with positive rolldown and a positive bias towards high VOL (extreme move in rates) as well – a combination of properties that we find attractive.
Another motivation for the trade is that it is likely that the markets will test Fed’s credibility again in terms of its promises to keep rates low for long, i.e. the markets will try to push forward the pricing of a first Fed rate hike again – in particularly if the economy improves going into next year. This should benefit the position as well, as increased uncertainty about the Fed would make the money market curve less ‘hockey stick’ shaped.
We prefer scaling in to the position to keep some ammo dry for a worsening of the sentiment if the gridlock continues up until the deadline for the debt ceiling.
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