Thursday, March 14, 2013

US Short End Rates Mis-pricing

Below shows the unemployment rate in US vs the priced in change in rates forwards (q-o-q changes). The dotted blue line extrapolates the current trends in unemployment.


This suggest by late 2014, the Fed will hit its target of 6.5% unemployment rate, from where we can see active tightening. With a large QE portfolio, the tightening may be not in terms of QE exits but rates hikes. There is all chance Fed will sit on at least a part of its QE portfolio through maturities. This suggests the market pricing in the rate hikes considerably later that the official target is reached. This presents a very good opportunities to go short in the short term rates vs euro. The best points are 3m (caps). This can be structured in caps with positive carry. The risk being a flare up of crisis in euro leading to a funding crunch in the region and a spike in short term rates. This should be mitigated to some extent by transmitted funding pressure across the Atlantic, as well as a very large drop in euro exchange rate 

The underlying economic theme in US remains unchanged, as per the latest Fed Flow of Funds reports. The consumer credit going strong (along with corporate credits) where as de-leveraging continues in financial sector as well as in home mortgages - the key this year therefore, I think, is not the unemployment numbers, but rather housing recovery. That will determine the performance of this trade

Happy Pi day

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